(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 market.
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 European bank.
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 DTAs.” (Reporting By Christopher Whittall, Editing by Owen Wild)