(This story originally appeared on International Financing
Review, a Thomson Reuters publication)
* Lenders look to monetise future tax credits
* Regulators wary of reg cap trades
* Investors scrutinise complex, high-yielding deals
By Christopher Whittall
LONDON, Feb 21 (IFR) - European banks are lining up a new
breed of trades to boost regulatory capital in an effort to
provide investors with equity-like exposure while avoiding the
dilution of existing shareholders.
The concept of a bank issuing notes linked to its deferred
tax assets has been floating around since the ink dried on the
first draft of Basel III in 2010, but only recently began to
gain traction in the industry.
A marriage of convenience between yield-hungry investors and
banks keen to meet regulatory requirements ahead of time has
increased the likeliness of these complex deals coming to
Regulators are wary of financial engineering in any guise
these days but bankers are confident of success, with as many as
a dozen institutions examining ways to monetise the billions of
euros of DTAs they hold on their balance sheets.
"It's something we've been looking at for a number of years
now. I fully expect some significant DTA-linked transactions to
be closed this year," said Adrian Docherty, head of bank
advisory at BNP Paribas.
"Regulators are determined not to be arbitraged, so any
transaction would have to have real economic substance, meaning
the risk of DTAs not being used up would have to be fully borne
by the end-investor," he said.
DTAs are an accounting concept - a potential future
deduction from a bank's taxable profit as a result of it posting
a loss in previous years. As these are intangible assets with no
value if a firm folds, DTAs are deducted from capital ratios
under Basel III.
Capital-strapped banks argue that partly reversing these
deductions is a valid balance sheet management tool alongside
more commonplace practices such as shedding risky assets or
issuing contingent capital debt.
Bringing these tax credits forward would boost a bank's
capital and leverage ratios in one fell swoop by tens of basis
points, according to one investor, who has signed preliminary
term sheets with three different banks on DTA-linked deals.
Banks have DTAs in abundance. Of the large European banks -
which are struggling to meet Basel III more than their US peers
- Deutsche Bank had over EUR7bn at the end of September last
year, Barclays held GBP5.8bn at year-end, BNP Paribas EUR7.6bn,
Credit Suisse CHF5.6bn and UBS CHF8.8bn.
In theory, DTA-linked notes behave like equity: both take
positive views on the future profitability of the bank. The
major difference is the complexity of the underlying structure.
DTAs are divided across a bank's operating companies and would
only be used if the bank earned profits in a particular region.
Investors would also be vulnerable to any changes in tax law.
"These practical aspects represent very high hurdles to ever
closing a deal," said the head of credit structuring at a
US regulators have effectively ruled these transactions out,
according to John Taylor, a tax partner at EY.
"Even in Europe I think there's a great deal of scepticism
among the accounting firms that these DTA-linked notes could
work," he said. "An accountant would say you've raised cash and
issued debt, that's how you should record it, not as proceeds
from the sale of a DTA."
Still, others are confident of winning regulators over by
structuring trades that involve a real economic risk transfer.
While banks are tinkering with various structures in bond, swap
and insurance formats, the concept in each case is comparable to
a structured note. An investor fully collateralises a chunk of a
bank's DTAs - most likely in the region of USD500m - for a
pre-agreed length of time, usually three to seven years.
The principal in the structure is transformed into more
senior liabilities as the bank rakes in profits and uses up its
DTAs. If the profits do not materialise, the investor is on the
hook to absorb these capital losses. In return, the investor
receives a coupon, which is either fixed at the outset or varies
as the DTAs are consumed.
Yields vary but are likely to be benchmarked against a
firm's junior debt plus a premium to reflect the illiquidity and
complexity of the structure. Some notes will also convert into
equity at maturity as a sweetener for investors.
A head of financial institutions advisory at another
European bank drew a comparison with the fledgling CoCo market,
with a variety of bespoke structures being considered to suit
individual banks. He says his firm is working on formats that
simplify the due diligence process, which is burdensome even for
this sophisticated investor base.
"These deals are similar to equity in that you're taking a
view on the performance of the business," he said. "They are
actually lower risk than CoCos if the transaction is long-dated
enough, and you have more visibility on past performance of the
(Reporting By Christopher Whittall, Editing by Owen Wild)