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Fitch: Spanish Banks' Deferred Tax Move Largely Cosmetic 01 Aug 2013 8:07 AM (EDT) Fitch Ratings-Barcelona/London

-01 August 2013: A potential change in Spain's tax regime to allow banks to convert part of their deferred tax assets (DTA) into a transferable tax credit to boost Basel III capital ratios is largely cosmetic and likely to be ratings neutral for Spanish banks and the sovereign, Fitch Ratings says. The DTAs were already included in our capital shortfall stress estimate for the banking sector, and so are already factored into our bank and sovereign ratings. The Spanish banks are looking to convert up to EUR30bn of their EUR50bn DTAs into tax credits, according to media reports. This move would boost their Basel III capital ratios as the tax credits would no longer have to be deducted from common equity Tier 1. This would be particularly helpful because capital and profitability remain under pressure from the challenging operating environment.

The impact of the potential change varies across banks and may be very pronounced, for example, for Banco de Sabadell, which estimated a fully loaded Basel III core capital ratio of 4.9% for end-2013 compared with an end-Q113 Tier 1 capital ratio of 10.6%. A substantial part of the difference is attributable to DTAs.

We would view this boost to regulatory capital as largely cosmetic and broadly neutral to the solvency of Spanish banks because the potential change would not benefit our primary measure of bank capitalisation - Fitch core capital (FCC). We already incorporate DTAs arising from temporary differences in provisions into FCC because they would bring a real tax benefit if the loan impairment they stem from crystallises into genuine loan losses. When the available capital amount is being reduced by anticipated loan losses, we consider it appropriate to recognise the connected anticipated tax credit as well. To the extent disclosure allows, we only deduct DTAs relating to losses carried forward from reported equity as they would have no tangible value if a bank continues to makes losses or undergoes resolution.

Nevertheless, Fitch's ratings take into account the benefit derived from higher regulatory capital ratios in boosting investor confidence in banks' solvency, which can ultimately improve banks' access to funding and their liquidity profiles.

Our EUR50bn-60bn capital shortfall stress estimate in June 2012 was based on banks' post-tax earnings and would be unaffected if the DTAs were converted. The existing DTAs already represented an effective narrowing of the sovereign's future corporate tax base. Were these to be turned into more fungible tax credits the long-term fiscal picture would not materially alter. This would probably not lead to an upfront increase in public debt, as the tax credits are likely to be treated as a contingent liability. We project a peak debt/GDP ratio of 99%.

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The Spanish banks' DTAs mainly arose from losses and loan impairment charges, which were particularly pronounced in 2012. The tax credit would be recognised by allocating collective impairment to specific loans. Under Basel III's stricter common equity definitions being phased in from 2014, deductions are required for all DTAs that rely on future profitability to be realised. We therefore expect the potential changes to target DTAs arising from loan impairment charges, similar to the reform Italy made in 2011.

This would allow the banks to avoid partial DTA deductions arising from timing differences between collective impairment charges in financial reporting and tax recognition of the provision required under Basel's limited recognition approach. In regimes where such DTAs are transformed automatically into a claim on the government when an institution makes a loss, is liquidated or placed under insolvency proceedings, banks will not need to deduct these DTAs.

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