ECB Questions New Eurozone Banking Loophole

BRUSSELS--The European Central Bank has raised concerns over legal changes in several countries that allow banks to continue using tax assets to boost their capital buffers, a practice that was meant to be phased out under new European Union rules.

The ECB worries that the changes in Italy, Spain, Portugal and Greece expose taxpayers in those countries to risks in case the banks run into trouble in coming years. The changes may also reduce pressure on lenders to seek outside capital.That could undermine the effectiveness of a new round of stress tests, whose results will be published later this month, the central bank fears.

"We don't like it, but there is nothing we can do about it," an ECB official said about the changed treatment of so-called deferred tax assets.

The ECB's misgivings are also spelled out in a legal opinion it published last month on a planned law on the treatment of these assets in Portugal, which followed earlier moves by Italy and Spain.

"The ECB recommends that the Portuguese authorities carefully assess the implications of the draft law from the perspective of fiscal debt and sovereign debt sustainability, and that they also take into account the need to break the link between the banking sector and sovereign debt," the ECB wrote.

The Portuguese law has since been passed, as has similar legislation in Greece.

At the heart of the ECB's concerns is the transformation of deferred tax assets into credits that give banks a much more direct claim on government coffers. When banks post losses or take big write-downs on their holdings, national authorities often grant them rights to redeem some of the taxes they paid during the unprofitable period at some point in the future.

Banks can then deduct these claims from their tax bill if they return to profit. To underscore their value, banks have been adding their deferred tax assets to their capital buffers.

New EU capital rules passed last year mandated that deferred tax assets that depend on future profitability should be gradually subtracted from a bank's core capital by 2018, since they aren't actually available if banks run into trouble before the taxes can be retrieved. That regulatory change would have hit banks in southern European countries particularly hard, as they piled up billions of euros in tax assets during the region's economic crisis.

In response, governments allowed banks to transform some of their deferred tax assets into tax credits or backed them with public guarantees. That means tax claims can be redeemed not just when a bank posts a profit, but also if it faces insolvency, for instance if its capital slips below regulatory thresholds.

At that moment, governments might be forced to take a stake in these lenders. Crucially, they could do so without having to impose losses on shareholders and subordinated creditors, at odds with new EU rules for regular government bailouts.

"This is money from the banks directly from the taxpayers," said Nicolas Véron, a visiting fellow at the Peterson Institute for International Economics in Washington.

The ECB doesn't have official estimates on the overall impact of the conversion from assets to credits in Italy, Spain, Portugal and Greece. However, the official said that the credits could amount to tens of billions of euros.

When the Spanish law was passed last year, Finance Minister Luis De Guindos said it could lift banks' capital levels by as much as EUR30 billion, allowing them to include some 60% of their total deferred tax assets. The country's largest lender, Banco Santander SA, had EUR21.07 billion in deferred tax assets at the end of 2013, of which EUR7.9 billion still count toward its core capital. Nationalized Bankia SA was able to include EUR5.25 billion of its EUR7.38 billion in deferred tax assets.

Portugal's largest bank, Banco Comercial Português SA, said last month that the new law on tax credits added an extra EUR1.9 billion, or 4.05 percentage points, to its core capital ratio. Banco BPI SA, the second largest-bank, said its core capital was lifted around EUR200 million, or 1.25 percentage points.

In its legal opinion, the ECB warned not only about the risk to taxpayers from the new laws. It also said that allowing banks to count the tax claims as capital may stop lenders from seeking new funds from private investors. "The conversion of DTAs into tax credits might reduce the incentive and/or the regulatory need for shareholders to inject fresh capital into credit institutions," it wrote.

Patricia Kowsmann contributed to this article.

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