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February 24, 2014

European Banks Are Cooking Up a Nice Regulatory Arbitrage

“I don’t have much to add to this International Financing Review article titled “Banks target DTAs to boost capital,” but it brought tears of joy to my eye, and I’ll pass it along because at least some of my readers share at least some of my aesthetic sensibilities. That’s probably a minority, even of my readers. Honestly this is some kinky stuff. But if you like this sort of thing, this is the sort of thing you’ll like.

“The story is that regulators require banks to have a certain amount of capital. Capital is — and everything I say here is very approximate and schematic, just go with it — but the way you figure out capital is that you add up all the bank’s assets, then you subtract its liabilities, and what’s left over is capital. And regulators want you to have more of that. One way to get more of that is to go sell stock, but that is expensive. Banks would prefer to get more capital using magic, because magic tends to be cheap.

“Now “add up the assets and subtract the liabilities” is roughly how you calculate capital, but it’s not quite that simple. In particular, some assets don’t count. Most of the obvious assets — stocks, bonds, buildings, whatever — count, but various intangible things don’t count. For instance, deferred tax assets don’t count. DTAs are the present value of future tax deductions due to past losses. So if you lost a lot of money in the past, you get to carry forward those losses to reduce your taxes in the future, and — for accounting purposes — you get to treat that reduction as an asset now.”

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Read full Bloomberg article here

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