Deferred Tax Assests and Bank Regulatory Capital

Abstract: In this study, I examine three issues: (1) whether the probability of bank failure is increasing in the proportion of regulatory capital composed of deferred tax assets (DTA), (2) whether market participants incorporate the increased failure risk associated with the DTA component of capital into their assessments of credit risk, and (3) whether the rules governing the inclusion of DTA into capital encourage risk-taking behavior. Using a sample of U.S. commercial banks, I find that banks that had a larger proportion of capital composed of DTA at the beginning of the recent recession were more likely to fail during the recession, even after controlling for other determinants of bank failure. Furthermore, using a sample of U.S. bank holding companies, I find that banks with a larger percentage of regulatory capital composed of DTA have lower credit ratings and higher bond spreads, with the effect varying negatively with expected profitability. Finally, I find evidence that poorly capitalized banks increased risk-taking to count more DTA towards capital requirements. These findings contribute to the ongoing debate regarding the inclusion of DTA in regulatory capital, as well as the literatures examining the valuation of DTA and the association between regulatory capital and credit risk.