Bank capital rules and taxes - more dodges ahead!

This post is a little wonkish, but we'll put it up anyway.

For those who have been following the setting of rules for international banks, the big show in town has been the Basel Committee on Banking Supervision, which is seeking to get banks to hold far higher levels of capital (in comparison to their assets that they hold) than they were before the crisis. Or, to use more technical language, the Basel Committee has been seeking to shut the stable door after this horse has bolted.

To simplify, banks are required to hold capital as a safety buffer, so that if things go wrong they have a comfort cushion of spare money that they can use to shore up battered finances in a crisis. Ahead of the latest global financial crisis, through regulatory arbitrage via tax havens and otherwise, banks ran their levels of capital down to almost zero - and, surprise, surprise, when crisis hit, they didn't have a cushion - and taxpayers had to bail them out instead.

It's a funny thing, bank capital. You might think it was made up of shrink-wrapped piles of banknotes sitting in a vault somewhere, ready to wheel out by the pallette on forklift trucks, on a rainy day. But no - all manner of different beasts have been allowed to qualify as bank capital, with different degrees of risk attached to each. There are bonds, some of which are riskier than others, and a menagerie of other instruments.

One of these instruments is so-called Deferred Tax Assets, or DTAs. Put simply, as Reuters explains:

"If a company has a loss on the income it reports to investors, but cannot record the loss for tax purposes until the future, it records a deferred tax asset, which reflects the future cash flow from paying lower taxes."

In other words, if it makes a loss, it will be able to carry this loss forwards into the future, and when it is making profits again it will then offset this loss against its tax bill on those profits. So it's counted as an asset: something that is worth money to the bank, albeit in the future. And regulators have been allowing banks to use these assets as bank capital, for goodness' sake.

This is important stuff: according to one story, Citigroup had a cool $47 billion DTAs by 2009, about half counted as top-rated capital. Over half of Allied Irish Banks' top-rated capital is made up of this stuff.

But there's one problem with using DTAs as bank capital. And it's a big one. As FT Alphaville puts it:

"They rely on banks generating enough profit in the future to actually be able to use them. And what are the odds a bank will be making money when it needs capital the most?
. . .
DTAs make an especially poor form of capital, since they only apply if banks are making enough money. In times of losses they’re almost completely useless."

In other words, the moments of crisis, when you will need this capital the most - are precisely the moments when you won't be able to access these assets - because you won't have profits that you can offset these DTAs against.

OK, it's a tiny bit more complex than that (see this, for some grisly details, if you wish, but the basic truth holds.)

Dozy (or complicit) regulators in Basel which have allowed this scam to go on for some time seem to be wising up to the problems with DTAs at last, and now want it excluded from so-called Tier 1 capital, which is the part of capital that is supposed to be least risky.

Given the vast subsidy that taxpayers have already larded onto the banks' shareholders, is that too much to ask? Apparently so. From the Financial Times:

"The more entrepreneurial investment banks – traditionally the likes of Goldman Sachs, JPMorgan and Deutsche Bank in this kind of area – have spent recent weeks touting new product ideas to banks that will be hit by the new rules.

The initiatives are focused in particular on ways in which deferred tax assets – to be outlawed as capital under current Basel thinking – can be turned into cash or an equivalent that would be valid for capital purposes."

Many bankers will support the initiatives as good creative thinking. But critics will see them as the latest evidence that banks have not learned their lesson from the crisis and will always focus on arbitraging the system for a profit, however tough the rules."

Just one more of those little stories about Big Finance to make you bring up your breakfast.