Greek banks’ capital and the mirage of deferred taxes
The Basel III agreements signed in 2010 provide for a transition phase before the new requirements are fully implemented. Planned between 2014 and 2019 for the risk-weighted capital ratio, this phase has been incorporated into the CRR/CRD4 directive[1]. The transition from Basel II to Basel III has resulted in particular in a strengthening of the quality of capital (Common Equity Tier 1 – CET1[2]) and an increase in deductions[3], in particular deferred tax credits, were removed (BIS, 2011).
Deferred tax credits
A deferred tax credit is like a receivable, except that the debtor is not a customer, but the government, or more specifically, its tax administration. Companies can find themselves owed money by their tax office in several ways: having made losses in the previous year, they can claim a tax credit for the following fiscal year, or having paid excessive estimated tax, they are entitled to deduct this excess from their contribution for the following year. So instead of reimbursing the company directly, the government reduces the tax bill. Thus, companies with deferred taxes are only able to recover their credit when they generate taxable income. Deferred tax credits are therefore conditional receivables from the government.
The case of banks in peripheral countries
Based on data made available to the public following stress tests conducted by the ECB and the EBA in November 2014, the capital of banks in fragile European countries consists mainly of these elements, which are set to disappear by 2018.
Transitional arrangements set to disappear by 2018 (end of 2013),
left scale in % of CET1 and right scale in billions of euros
Source: Arnould and Dehmej (2015), EBA, BSI Economics.
Notes: The case of negative arrangements in Luxembourg and Malta is due to the new inclusion of unrealized profits in the available-for-sale portfolio, which exceed the assets deducted from CET1.
This sword of Damocles mainly affects Greek (76%), Irish (64%) and Portuguese banks. However, when it comes to tax credits, Greek banks are particularly exposed, with 52% of their CET1 capital consisting of deferred tax credits, representing €10 billion (ECB, 2014).
Low-quality capital
Deferred tax credits are claims by banks on their governments, thereby reinforcing the dependence between the banking system and national sovereign debt and increasing the risk of activating a « vicious circle » in which any support for the banking sector increases the national debt and thus the quality of the banks’ assets, which may once again find themselves in difficulty. In the case of Greece, a sovereign default would probably mean the cancellation of these deferred taxes and thus the disappearance of a major portion of Greek banks’ capital.
It should also be borne in mind that these deferred taxes on the capital of European banks were mainly created when the banks suffered losses and can only be repaid if they make a profit, which is far from being the case for Greek banks.[4].
Despite a withdrawal from the definition of the capital scope planned for 2018, Spain, Portugal, Italy, and Greece have put in place an accounting arrangement allowing their banks to retain these deferred tax credits by removing their « deferred » status, i.e., by converting them into an equity equivalent, making the states shareholders in the banks and exposing them even more[5], or by issuing them on the market in the form of financial securities.
A procedure to evaluate this accounting arrangement was launched by the European Union in April 2015 to determine whether it constituted indirect government aid, in violation of European competition laws[6].
Notes:
[1] These directives transpose the Basel III recommendations into European law.
[2] CET1 accounts for between two-thirds and three-quarters of capital requirements under Basel III (BIS, 2011).
[3] Mainly intangible assets, cross-holdings, unrealized gains within the available-for-sale asset portfolio, and deferred tax credits based on future income, see BIS (2011).
[4] For example, the National Bank of Greece posted an annualized net loss of $688 million in March 2015.
[5] Under a resolution plan for a failed bank, shareholders are the first to absorb losses, well ahead of creditors.
[6] See the article in the FT or Reuters.
References:
ECB, 2014, « Aggregate report on the comprehensive assessment, » October 2014
FT, 2015, “EU considers probe into unfair state aid for south European banks”, April 6, 2015
Reuters, 2015, “EU mulls probe into ‘deferred tax assets’ of southern Europe’s banks”, April 6, 2015
