In determining their strategy toward problem country loans, creditor banks have clearly been influenced by the regulatory, accounting, and tax regimes of the countries in which they are based. These regimes are important because they determine the impact of financial operations on a bank’s profit and loss account and on its capital position. Other things being equal, a bank would structure its operations to provide favorable signals to the market through its accounts and would seek to avoid sharp reductions in reported income. Moreover, a bank will seek to minimize needs for capital and provisions so as to limit the costs of funding its assets. So, for example, the incentive for a bank to agree to new money will tend to be inversely related to the provisioning required against the increase in exposure.
With regard to debt reduction, regulatory, accounting, and tax policies determine the extent to which a bank conceding a reduction in principal or interest due must record an immediate loss on the operation and the degree to which capital and provisions must be subsequently replenished. In general, the higher the level of provisions, the greater is the cost of carrying existing claims and the less is the additional cost of realizing the loss, both in terms of reported income and capital, although the impact on capital may be softened (and indeed, in some circumstances, reversed) by tax relief. Policies that provide banks with flexibility in distributing reported losses over time, reduce the impact of the operation on capital and provisioning needs, take appropriate account of accompanying debt enhancement, and allow banks to achieve greater tax relief, all tend to reduce the immediate costs to banks of participating in debt reduction. Policies in these areas also tend to influence banks’ preferences about the form of debt reduction to the extent that regulatory, accounting, and tax treatment may apply differently to alternative options.
During the past year, a number of developments in the regulatory, accounting, and tax areas have generally made it more attractive for creditor banks to accept debt reduction, while at the same time reducing incentives to provide new money. In particular, a number of banks in Canada, the United Kingdom, and the United States—countries where provisions had previously been relatively low—chose to increase their provisioning by substantial amounts. As a result, most major creditor banks outside Japan have reserved against at least half of their gross exposure to problem countries and many banks have considerably higher levels of provisions.
In addition, in the period following the announcement of the strengthened debt strategy, national authorities launched a collaborative effort to identify and address potential impediments to the process of debt reduction, which led to a clarification of how existing accounting and regulatory rules and tax laws would be applied in this context. Of particular note, in the United States, it was announced that banks participating in the Mexican debt exchanges would be expected to follow existing accounting literature that permits the losses arising from these exchanges to be amortized over time rather than shown up front; this clarification made it easier for capital-weak banks to participate in the exchanges. In Japan, the authorities indicated that existing tax laws would allow banks that participate in the Mexican exchanges to claim tax deductions and that the ceiling on bank provisions would be progressively phased out.
Provisions Against Existing Claims
Regulatory, accounting, and tax treatment of provisions against existing bank claims on problem countries has varied significantly among the main creditor countries.47 In most continental European countries, regulators moved quickly following the onset of the debt crisis to encourage banks to build up country risk provisions, and on average provisions in these countries exceeded 50 percent of problem country claims by the end of 1988 (Table 14). Provisions in these countries are excluded from capital (except in France), but the tax authorities have partly offset the cost to banks of these provisions by allowing banks to apply increases in provisions as a deduction from taxable income. Similar regulatory and tax policies have been subsequently adopted in Canada and the United Kingdom. Provisions in these countries at the end of 1988 amounted to about 45 percent and 35 percent, respectively, of problem country claims. During 1989, some U.K. banks raised their provisions by substantial amounts (up to 85 percent of medium- and long-term claims in one case), well in excess of regulatory requirements or levels qualifying as tax deductions; Canadian banks also increased provisions significantly in the past year.
Commercial Bank Provisioning Against Claims on Developing Countries
(End of 1988; unless otherwise specified)
In percent of relevant exposure; numbers indicate range for major banks. Comparisons across countries are difficult because of the different tax and regulatory status of provisions and because of differences in the exposure base.
Indicates whether provisions are included in the capital base used for monitoring capital asset ratios.
End of September 1989.
Adequacy judged against industry average.
End of March 1990.
Except that provisions of 50 percent of exposure are required when a claim has not been serviced for three years.
Only the non-tax-deductible portion is included.
End of December 1989.
Except those loans against which regulators mandate an Allocated Transfer Risk Reserve.
Commercial Bank Provisioning Against Claims on Developing Countries
(End of 1988; unless otherwise specified)
| Range of Provisioning1 | Mandatory Provisioning | Tax Deductibility of Provisioning |
Gearability2 | |
|---|---|---|---|---|
| Belgium | 30–100 43 average | 30 percent against a basket of 38 countries | No | No |
| Canada | 70–90 75 average3 | 35–45 percent against a basket of 42 countries. | Up to 45 percent | No |
| France | 40–61 51 average | 38 percent against a basket of about 75 countries | Yes; but case by case for provisioning in excess of average | Yes |
| Germany, Fed. Rep. of | 37–77 53 average | No4 | Yes, but case by case | No |
| Japan | 255 | 1–25 percent against a basket of 40 countries6 | Limited to 1 percent of rescheduled debt and increased exposure6 | Partly7 |
| Netherlands | 50 average8 | 10–90 percent depending on country, for 38 countries | Yes, but case by case in excess of mandatory provisioning levels | No |
| Switzerland | 35–75 56 average | 50 percent against a group of about 65 countries | Yes; but on a case-by-case basis for provisioning in excess of mandatory levels | No |
| United Kingdom | 48–85 60 average3 | Bank of England guideline: 5 percent to 100 percent depending on country, for 38 countries | Yes, but only up to Bank of England guideline | No |
| United States | 36–100 46 average8 | No9 | No9 | Partly7 |
In percent of relevant exposure; numbers indicate range for major banks. Comparisons across countries are difficult because of the different tax and regulatory status of provisions and because of differences in the exposure base.
Indicates whether provisions are included in the capital base used for monitoring capital asset ratios.
End of September 1989.
Adequacy judged against industry average.
End of March 1990.
Except that provisions of 50 percent of exposure are required when a claim has not been serviced for three years.
Only the non-tax-deductible portion is included.
End of December 1989.
Except those loans against which regulators mandate an Allocated Transfer Risk Reserve.
Commercial Bank Provisioning Against Claims on Developing Countries
(End of 1988; unless otherwise specified)
| Range of Provisioning1 | Mandatory Provisioning | Tax Deductibility of Provisioning |
Gearability2 | |
|---|---|---|---|---|
| Belgium | 30–100 43 average | 30 percent against a basket of 38 countries | No | No |
| Canada | 70–90 75 average3 | 35–45 percent against a basket of 42 countries. | Up to 45 percent | No |
| France | 40–61 51 average | 38 percent against a basket of about 75 countries | Yes; but case by case for provisioning in excess of average | Yes |
| Germany, Fed. Rep. of | 37–77 53 average | No4 | Yes, but case by case | No |
| Japan | 255 | 1–25 percent against a basket of 40 countries6 | Limited to 1 percent of rescheduled debt and increased exposure6 | Partly7 |
| Netherlands | 50 average8 | 10–90 percent depending on country, for 38 countries | Yes, but case by case in excess of mandatory provisioning levels | No |
| Switzerland | 35–75 56 average | 50 percent against a group of about 65 countries | Yes; but on a case-by-case basis for provisioning in excess of mandatory levels | No |
| United Kingdom | 48–85 60 average3 | Bank of England guideline: 5 percent to 100 percent depending on country, for 38 countries | Yes, but only up to Bank of England guideline | No |
| United States | 36–100 46 average8 | No9 | No9 | Partly7 |
In percent of relevant exposure; numbers indicate range for major banks. Comparisons across countries are difficult because of the different tax and regulatory status of provisions and because of differences in the exposure base.
Indicates whether provisions are included in the capital base used for monitoring capital asset ratios.
End of September 1989.
Adequacy judged against industry average.
End of March 1990.
Except that provisions of 50 percent of exposure are required when a claim has not been serviced for three years.
Only the non-tax-deductible portion is included.
End of December 1989.
Except those loans against which regulators mandate an Allocated Transfer Risk Reserve.
In other creditor countries, regulators have accepted lower levels of country risk provisions and have generally allowed such provisions to be included within capital; however, provisions are eligible for only a limited degree of tax relief. In the United States, money-center banks had established general loan-loss reserves averaging about 30 percent of exposure at the end of 1988, but many banks raised provisions significantly during 1989, and the average rose to 46 percent of exposure. In addition, banks have been required by regulators to constitute Allocated Transfer Risk Reserves (ATRRs) against claims on a limited group of countries that have been classified by regulators as “value impaired.” The ATRRs, unlike general loan-loss reserves, are tax deductible and excluded from capital. In Japan, banks have been permitted to provision up to at most 15 percent of eligible problem country claims with provisions of up to 1 percent of certain claims being tax deductible. In January 1990, the authorities indicated that the ceiling on provisioning would be progressively phased out, and as a first step, it was increased to 25 percent of claims through March 30, 1990.
The differences between countries in the treatment of provisions in assessing capital adequacy will be reduced by the application of the capital adequacy guidelines developed in the framework of the Basle Committee of Bank Supervisors. Under these guidelines, which are to be fully in place by the end of 1992, specific provisions are to be entirely excluded from capital. General provisions are to be excluded from core capital but may be included in supplementary capital up to a maximum of 1.5 percent of risk-weighted assets from the end of 1990 and 1.25 percent of risk-weighted assets from the end of 1992, or up to 2 percent of risk-weighted assets under exceptional and temporary circumstances. U.S. regulators have indicated that from the end of 1992 banks’ use of provisions in capital would, in fact, be restricted to the 1.25 percent limit at all times.
There are substantial variations between countries in the form of the guidance that regulators give to banks on appropriate provisioning levels. A number of countries, including Belgium, Canada, the Netherlands, and Switzerland, have issued regulations that specify quite precisely the minimum level of provisioning required, the type of claims against which provisions need to be held, and the list of countries that are included in the category of troubled debtors. Regulators in other countries, such as France, provide no specific indications as to how provisions should be allocated between type of claim or country but do give guidance to banks on the overall level of provisions that is appropriate. In the United States, banks receive mandatory instructions on constituting ATRRs but must establish general loan-loss provisions on the basis of broad prudential guidelines. In Japan, banks are generally not permitted to provision in excess of a given percent of exposure in order to maintain uniformity in provisioning levels. In the United Kingdom, the Bank of England has provided banks with a detailed matrix of criteria with which to assess provisioning needs against different countries. Creditor banks are then required to make their own judgments as to the appropriate level of provisions within the range indicated by the matrix, based on their assessment of the quality of their claims, but would need to justify provisioning levels well below the matrix ranges. In the Federal Republic of Germany banks are required to make their own assessment on country risk provisioning subject to review by external auditors; banks would be subject to regulatory pressure if it were judged that such provisions were insufficient.
Decisions on the tax treatment of provisions are generally made by national tax authorities, and need not be fully consistent with regulatory requirements, although in practice tax authorities have usually accepted that provisions required by bank regulators should be allowed as tax deductions. Thus, provisions required in Canada, France, the Netherlands, and Switzerland and ATRRs in the United States qualify as tax deductions, although in Belgium mandated provisions have not so qualified. In the United Kingdom, discussions are still continuing between creditor banks and the Inland Revenue on how the matrix should be applied for the 1987 and 1988 tax years, and it is not yet certain that the tax authority will accept the maximum level of provisioning suggested by the matrix as fully tax deductible.
The situation is less clear where bank provisions are in excess of required levels. In Canada, the United Kingdom, and the United States, the tax authorities have resisted allowing tax deductions on provisions over and above levels specifically required by regulators. In France, the Netherlands, and Switzerland, the tax authorities have generally allowed banks on a case-by-case basis to apply provisions in excess of the required levels as tax deductions. In the Federal Republic of Germany, where regulators have not provided specific indications of appropriate provisioning levels, the tax authorities are reported to have allowed banks to claim tax deductions on provisions up to about 70 percent of claims, but in certain cases have challenged the tax deductibility of additional provisions. In the Federal Republic of Germany and Switzerland, the matter is further complicated by the fact that taxes on bank income are administered at the state or cantonal level, and that rulings on the tax deductibility of provisions need not be identical in different jurisdictions. Moreover, in a number of countries, including Germany and Switzerland, tax decisions made by banks are only reviewed by the authorities after a number of years. In the interim period, there may be considerable uncertainty about whether a tax deduction claimed on the basis of high provisioning will ultimately be sustained.
New Financing
New money provided as part of a concerted lending package has generally been treated for regulatory purposes in the same way as existing claims. Thus, banks are able to book the new loans at full face value but are typically required to establish provisions on the new loans in the same proportion as those on existing claims. An exception to this rule is that in the United States new money to a country whose existing bank debt is rated as “value impaired” would not necessarily be subject to the ATRR. Provisions against new money are normally tax deductible to the extent that provisions on existing claims are tax deductible.
With regard to interest capitalization, in most creditor countries, new financing in this form would seem, in general, to have no special regulatory, accounting, or tax implications. The capitalized interest would usually be registered as income on the profit-and-loss account and as an increase in assets on the balance sheet that would need to be provisioned in the same proportion as existing claims. However, in the United States, capitalized interest on a loan whose ultimate collectibility has been placed in doubt may not generally be counted as income for financial accounting purposes, but might nevertheless be subject to tax. This treatment has discouraged the use of interest capitalization as a technique of new financing.
A buildup in interest arrears on sovereign debt beyond at most 180 days generally triggers special accounting and regulatory treatment that effectively excludes unpaid interest from the profit-and-loss account and from taxable income (Table A37). Once arrears are cleared and interest payments are resumed, most regulatory authorities would allow such payments to enter immediately into income. However, this would not necessarily be the case in the United States, where Federal Accounting Standards set conditions for payments received after an interruption to be applied against principal (although this accounting rule has yet to be used in the context of sovereign loans). In general, however, a return to accrual accounting of income would need to be justified by a period of performance following complete clearance of arrears. In some countries, arrears may also have implications for provisions against existing exposure. In the Federal Republic of Germany, the Netherlands, and the United Kingdom, the emergence of arrears is a factor to be considered in assessing the appropriate level of provisions. In the United States, arrears of over 180 days are one of the conditions that may lead the Interagency Country Exposure Review Committee (ICERC) to require the setting up of an ATRR. In these countries, clearance of the arrears would not necessarily lead to an automatic reversal of the provisions but would be taken into account in an assessment of whether a fundamental improvement in conditions had occurred that would justify a reduction of provisioning.
Debt Reduction
In recent years, creditor banks have used a wide range of operations to reduce their outstanding claims on problem countries, both within the context of officially sanctioned schemes that may be presented as menu items in a restructuring package and through unofficial transactions between banks and private borrowers or third parties willing to acquire the claims. Initially, most of these operations fell into the general categories of loan sales or debt-equity swaps, and the regulatory, accounting, and tax treatment of such transactions is by now fairly well established. However, since the Mexico-Morgan debt exchange in February 1988, there has been increased interest in transactions in which existing claims are exchanged for new instruments with reduced principal or interest and with partial collateralization or guarantees of debt service payments. The possibility of such exchanges has raised a host of questions concerning their regulatory, accounting, and tax treatment.
Debt Buy-Backs
Creditor banks have sold claims for cash in officially sanctioned buy-back schemes with Bolivia, Chile, and the Philippines and more extensively on the secondary market, usually to investors seeking claims for use in debt-equity schemes. In general, a bank would need to recognize a loss in its profit-and-loss account on the transaction equal to the carrying value of the claim (i.e., book value net of provisions against the claim) less the value of the cash received. If the carrying value was, in fact, less than cash received, then the bank could conceivably need to show an accounting profit on the sale, although in practice the excess provisions could usually be reallocated to remaining claims. The loss for tax purposes would then usually be the loss shown in the profit-and-loss account plus, in countries where provisions are not eligible as tax deductions, the provisions expended in the transaction.
Regulatory and tax rules typically do not distinguish between officially sanctioned buy-backs and secondary market sales. In Japan, participation in nonofficial transactions was limited in the past because of uncertainty about (1) whether other claims on the debtor country in the bank’s portfolio would have to be written down to reflect the transaction price, and (2) whether the loss on the transaction would be allowed as a deduction from taxable income. Recently, however, Japanese bank participation in the secondary market has been more active as the authorities have indicated that contamination would be avoided and losses would be tax deductible under the existing tax code, provided that the transactions occur at a fair market value. In other countries, such as the United States, secondary market sales at a substantial discount have not triggered mandatory write-downs of remaining exposure but have been a factor that bank examiners would consider in assessing the adequacy of provisioning.
Debt Exchanges
Debt exchanges generally involve a reduction in claims—either through reduced principal or a lower interest rate—in exchange for some form of enhancement of the remaining obligations. While such restructurings are not uncommon in the context of domestic bankruptcy proceedings, experience with sovereign debtors has been largely limited to the Mexico-Morgan exchange of February 1988 (which involved a reduction in principal) and the bank package with Mexico negotiated in 1989 that offered a discount exchange (with a reduction in principal) and a par exchange (with a reduction in interest). These operations raise three important issues that are now in the process of being resolved: first, how banks should value the new instrument on their balance sheet, second, how the new instrument should be treated for provisioning purposes, and third, how the exchange affects banks’ tax liabilities.
With regard to the valuation of the asset received in the exchange, accounting rules in most creditor countries generally require that banks book an instrument received in an exchange at its fair value if they intend to hold it to maturity, but to mark it to the lower of cost or market if the instrument is to be placed in the trading portfolio. This guideline, however, leaves considerable flexibility in interpreting the concept of fair value. In considering the Mexico-Morgan exchange, the authorities in Canada, the Federal Republic of Germany, and the United States indicated that in determining fair value, banks should look first to the market value of the asset. However, given that the secondary market for the instrument was thin, it was not clear that the price in the market was indeed a good indication of fair value, and, in the end, banks were required to make their own prudent valuation. In practice, banks apparently did not apply a uniform approach, and valuation ranged between the carrying value of the loan exchanged and the market value of the security received (Table 15). In Belgium, France, Japan, and Switzerland, banks were permitted to book the new instrument at its face value, which in some cases was above the carrying value of the loan exchanged. In the United Kingdom, banks were required for supervisory purposes to value the instrument received at the lesser of the carrying value of loans exchanged and the face value of the instrument. Given these decisions, banks in most countries were generally able to avoid recognizing losses substantially in excess of provisions, although banks retained the option of marking to market where desired.
Regulatory, Accounting, and Tax Treatment of the Mexico-Morgan Debt Exchange
On the basis of instrument being held to maturity. If placed in the trading book, the instrument would need to be marked to the lower of cost or market.
Exchange did not require banks to add to provisions.
Banks had the option of excluding the instrument from Mexican exposure entirely provided that this was explained in a footnote in reporting statements.
Regulatory, Accounting, and Tax Treatment of the Mexico-Morgan Debt Exchange
| Belgium | Canada | France | Federal Republic of Germany | Japan | The Netherlands | Switzerland | United Kingdom | United States | |
|---|---|---|---|---|---|---|---|---|---|
| On what basis is the new instrument valued? | Face value of new security1 | Carrying value of loans exchanged | Face value of new security1 | Between carrying value of loans exchanged and market value of new security1 | Face value of new security | Lower of carrying value of loans exchanged and face value of new security | Face value of new security | Lower of carrying value of loans exchanged and face value of new security1 | Between value of loans exchanged and market value of security1 |
| Is the new instrument treated as Mexico risk for provisioning? | Yes, excluding present value of collateral | Yes2 | No | n.a. | No | Yes2 | No | Yes2 | Yes, excluding present value of collateral3 |
| Did participation in the auction have contamination effects? | No | No | n.a. | No | No | No | No | No | Yes |
| Did national banks participate to a significant degree in the exchange? | Yes | Yes | No | Yes | Yes | Yes | No | Yes | Yes |
| Does the securitization of the claim have tax implications? | No | No | Yes | No | No | No | No | No | No |
On the basis of instrument being held to maturity. If placed in the trading book, the instrument would need to be marked to the lower of cost or market.
Exchange did not require banks to add to provisions.
Banks had the option of excluding the instrument from Mexican exposure entirely provided that this was explained in a footnote in reporting statements.
Regulatory, Accounting, and Tax Treatment of the Mexico-Morgan Debt Exchange
| Belgium | Canada | France | Federal Republic of Germany | Japan | The Netherlands | Switzerland | United Kingdom | United States | |
|---|---|---|---|---|---|---|---|---|---|
| On what basis is the new instrument valued? | Face value of new security1 | Carrying value of loans exchanged | Face value of new security1 | Between carrying value of loans exchanged and market value of new security1 | Face value of new security | Lower of carrying value of loans exchanged and face value of new security | Face value of new security | Lower of carrying value of loans exchanged and face value of new security1 | Between value of loans exchanged and market value of security1 |
| Is the new instrument treated as Mexico risk for provisioning? | Yes, excluding present value of collateral | Yes2 | No | n.a. | No | Yes2 | No | Yes2 | Yes, excluding present value of collateral3 |
| Did participation in the auction have contamination effects? | No | No | n.a. | No | No | No | No | No | Yes |
| Did national banks participate to a significant degree in the exchange? | Yes | Yes | No | Yes | Yes | Yes | No | Yes | Yes |
| Does the securitization of the claim have tax implications? | No | No | Yes | No | No | No | No | No | No |
On the basis of instrument being held to maturity. If placed in the trading book, the instrument would need to be marked to the lower of cost or market.
Exchange did not require banks to add to provisions.
Banks had the option of excluding the instrument from Mexican exposure entirely provided that this was explained in a footnote in reporting statements.
With regard to interest rate reduction, there is no clear precedent of the appropriate accounting treatment in the context of sovereign lending, and it is necessary to draw information from the accounting treatment of domestic troubled debt restructuring.48 On this basis, it would seem that in most creditor countries, a substantial interest concession on an asset would not by itself normally lead to a presumption that the asset would need to be revalued in the balance sheet. The Federal Republic of Germany may be an exception to this; under German accounting procedures a significant reduction in interest rate on an asset would be generally regarded as a reason to write down the value of the asset.
In the United States, the financial accounting principles for troubled debt restructuring have been established by Federal Accounting Standard (FAS) 15. This ruling distinguishes between two types of restructuring: a transaction involving an exchange of assets from debtor to creditor in settlement of the debt and a restructuring involving only a modification of the terms of the existing claim. If the restructuring involves a creditor receiving an asset substantially different from the original claim, it must be accounted as an exchange, and the asset received by the creditor must be “fair valued.” If it involves only a modification of terms, the recorded investment may be left unchanged provided that the undiscounted sum of estimated future cash receipts (principal and interest) specified by the new terms are at least as great as the recorded investment.
At the time of the Brazilian financing package in 1988, the Securities and Exchange Commission (SEC) indicated that banks participating in the low-interest exit bond would apply FAS 15 to determine the extent of the required writedown. Further, it announced in September 1989 that the discount and the par exchanges in the 1989 Mexico debt restructuring would also be treated as modifications in terms under FAS 15. The Mexico-Morgan exchange in 1988, however, was classified as an exchange of assets, in part because of the auction process used in the restructuring. Moreover, the SEC required that all claims tendered in the Mexico-Morgan exchange auction, but not accepted, should be written down to the tender price (or be provisioned to cover the difference between book value and the tender price) on the grounds that tendering existing obligations to the auction is inconsistent with an intent to hold to maturity. Claims that were not offered for tendering could be kept at face value, but banks were reminded that loan-loss reserves needed to be adequate to cover potential losses.
Regulators in different countries have taken a variety of approaches toward the question of whether the instruments received in debt exchanges should be included in the measure of country exposure for provisioning purposes. With regard to the Mexico Morgan exchange, it was ruled in France, Japan, and Switzerland that the security could be excluded from the measure of exposure, which allowed banks to reallocate provisions against the exchanged loans to other uses to the extent that provisions exceeded the book loss on the exchange. In Belgium and the United States, the present value of the collateral was excluded from the measure of exposure, but the residual value of the instrument continued to be counted as Mexican exposure. This treatment implied that banks in these countries would have needed to increase provisions somewhat in order to maintain the previous ratio of provisions to exposure, given that their provisioning ratio was below the secondary market price.49 With regard to the 1989 Mexico discount exchange, however, the U.S. regulatory authorities indicated that a lower level of reserves would be acceptable provided that the new instrument was booked at par, was appropriately enhanced, and was being serviced in a timely manner. For the par exchange with interest reduction, the new instrument could be booked at par for regulatory purposes, provided that the sum of reserves (including the present value of the collateral) plus the fair value of the instrument equaled or exceeded the par value of the bond.
In the United Kingdom and the Netherlands, the supervisory authorities indicated that banks would not be required to make additional provisions as a result of either the 1988 or the 1989 Mexican exchanges. However, the instrument was to be fully included in the measure of Mexican exposure in the sense that if the country’s situation deteriorated, it would be necessary to establish additional provisions on the security as on other exposure. Similarly, in Canada the authorities indicated that the exchanges should have a neutral impact on provisions. Where banks took an up-front loss greater than the provisions held on the claim, banks could then reduce provisions on other claims to offset this loss. The claims would continue to be regarded as Mexican exposure if provisioning requirements were to be raised.
Tax factors may also affect banks’ attitudes toward debt exchanges. In most countries, the tax deduction arising from the Mexico-Morgan transaction was determined as the loss recognized for book purposes, plus the change in provisions where such provisions had not already been applied as a charge against taxable income. In the United States, however, since the 1986 tax reform, which restricted the use of general loan-loss provisions as a tax deduction, there has been increased divergence between financial accounting and tax accounting, and there is no presumption that the latter should necessarily follow from the former. In December 1989, the Internal Revenue Service published a ruling that holds that the loss in sovereign debt exchanges is to be determined as the difference between the tax basis of the claim exchanged and the issue price. For this purpose, the issue price generally is the lesser of (i) the face amount or (ii) the present value of all payments due under the instrument determined by using a discount rate equal to the applicable federal rate compounded semiannually. In Japan, in the case of the 1989 Mexican exchanges, the authorities have indicated that the tax codes allow banks to obtain a tax deduction equal to the difference between the face values of claims surrendered and bonds received in the exchange; the difference between the face value of the bonds received and their market value would also be deductible. Japanese banks are reported to have opted predominantly for the discount rather than par exchange, possibly reflecting the greater certainty over the value of the tax deduction to be obtained.
The tax benefits obtained from a deduction depend on a number of factors including marginal tax rates, the possibility of carry-forward or carry-back of tax deductions to other tax years, and sourcing restrictions on the income against which the tax deduction can be applied. Corporate income tax rates vary substantially among countries, and, in addition, banks in many countries are subject to a range of state and local taxes that may raise the effective tax burden significantly. Banks are generally given some flexibility to carry forward or carry back tax deductions if they exceed taxable income in the current year. In France and Japan, the maximum carry-forward is five years and there is a more limited provision for carry-back, while British and German banks may carry forward deductions for an indefinite period. In the United States, a loss attributable to an exchange is not subject to the limitations on carry-forwards and carry-backs applied to net operating losses of banks related to loan losses (10 years back, 5 years forward) but rather to the more generally applied allowance of 3 years back and 15 years forward.
There are two further factors that complicate the tax implications of debt exchanges in the United States. First, the value of a tax deduction depends in part on whether it is applied against domestic- or foreign-source income. Many banks have only limited potential tax liabilities on foreign-source income as a result of tax credits obtained on the basis of double taxation treaties in compensation for tax payments made abroad. In consequence, tax deductions applied against foreign-source income reduce the value of these tax credits, especially as the credits may only be carried back three years and carried forward five years. In May 1989, the Internal Revenue Service ruled that bank loan losses must be allocated between foreign and domestic sources in accordance with the percentage of foreign and domestic assets held by the bank on a consolidated group basis. Second, through 1989, many U.S. banks were subject to an alternative minimum income tax, which depended in part on the excess of book income over taxable income. Thus, until the end of the year, banks faced an incentive to avoid recognizing losses through participating in debt exchanges because such exchanges would reduce taxable income by more than book income to the extent that losses on the transaction were charged against provisions.
A particular tax problem concerning debt exchanges arose in France, where banks participating in the Mexico-Morgan exchange would have been required to treat the new instrument as a security for tax purposes. In consequence, banks would have been required to deduct losses experienced on the instrument from capital gains, which are subject to a 15 percent tax rate, rather than from interest earned on bank claims subject to a 42 percent tax rate.
Debt-Equity Conversions
In recent years, a large part of the debt reduction that has occurred has been in the form of debt-equity conversions, including both officially sanctioned schemes and operations to convert private sector debt. Creditor banks have participated in these schemes in a number of ways, through selling claims to potential investors on the secondary market, through acting as agents to facilitate transactions, and by participating directly to acquire equity stakes in banks or other companies in the debtor country. Acquisition of equity shares by banks has raised a number of accounting, regulatory, and tax issues.
The main accounting question is how to value the acquired equity claim on the balance sheet. In most creditor countries, the conversion from debt to equity is classified as an exchange of assets, and the equity acquired must be fair valued. The procedure used to assess the fair value of equity is, however, a complicated one, and would need to take into consideration a range of factors that could include the secondary market price of the debt exchanged, the value of local currency received for subsequent equity investment, the restrictions on repatriation of principal and dividends, the estimated cash flow from the investment, and the market value of similar equity investments.
With regard to regulatory treatment, equity shares obtained in a conversion would not normally be subject to provisioning requirements. However, banks in certain countries are restricted in the extent to which they can acquire equity claims, over and above standard restrictions that apply equally to the loan portfolio. In Japan, banks have only recently been permitted to acquire equity stakes in this way or to sell their own claims for debt-equity conversions. In the United States, the general restriction that banks could not hold more than 20 percent of a firm’s equity has been relaxed in recent years to facilitate bank participation in debt-equity conversion.
Participation in a debt-equity conversion may have important tax implications arising because an investor acquiring an equity claim would usually be liable to taxation on income or capital gains on that claim in the debtor country, while income on bank loans booked in the bank’s home country would not be subject to such taxation or would be protected by a clause in the loan agreement requiring that interest be paid net of withholding tax. In general, the cost of such taxation to the investor would be reduced where the investor is based in a country with a double taxation treaty with the debtor country that allows for tax credits against tax liabilities on foreign-source income.
Policy Issues
A number of observers have suggested that regulatory, accounting, and tax policies could be modified to encourage banks to participate in debt and debt service reduction rather than to hold on to existing claims. Such suggestions raise complex policy issues, some of which are addressed in this section.
Provisioning Policy
The variation in provisioning policies toward country transfer risk across the main creditor countries outlined above has clearly influenced bank attitudes toward participating in concerted lending and debt and debt service reduction. In particular, the cost in terms of capital and provisioning of extending new credits to problem debtors has generally been rather lower for banks in Japan and the United States than elsewhere, and this has been a factor that has influenced these banks to be more inclined toward participating in concerted new lending than banks in other countries. However, banks in all countries have been encouraged to contribute to such financing packages by the relatively restrictive treatment of the alternative, namely, the accumulation of interest arrears. In addition, the fact that regulatory authorities in most countries have not required provisions against short-term credits or interbank lending that have a good record of being serviced has contributed to the continued access of debtor countries to such sources of funding.
As regards debt reduction, higher provisioning by itself does not necessarily increase the incentive for banks to recognize losses through such operations. In this respect, it is noteworthy that U.S. banks with low provisions have been particularly aggressive in realizing losses through debt conversions, and that Japanese banks are reported to have been willing to participate in debt reduction options in the recently negotiated Mexican and Philippine bank packages described in Section III of this report.
In general the realization of a loss may have two costs for a bank: the cost of reporting lower income and the cost of replenishing capital. The cost of reporting lower income is clearly reduced the higher the level of existing provisions; indeed, where provisions are particularly high, banks might be required to recapture provisions into income where the discount implied in the operation was less than the provision against the claim. The effect of provisioning on the cost of replenishing capital after a loss is more ambiguous, however, and depends on a number of factors, including whether provisions used to offset the loss are part of the capital base and the degree of tax relief obtained.
In countries where provisions generally are included in the capital base—France, Japan, and the United States—realizing losses through debt or debt service reduction will have a direct impact on bank capital, which is reduced by the full extent of the loss, less tax relief obtained. In Japan and the United States, however, provisions are tax deductible only to a very limited degree, and tax relief available upon realizing a loss could be substantial. Indeed, banks that face high marginal rates of taxation and for which the cost of raising additional capital is low relative to that of funding through deposits may find that realizing the loss actually reduces funding costs as tax benefits exceed the cost of raising additional capital.50 In France, provisions are generally allowed as a tax deduction, and the realization of the loss only brings tax benefits to the extent that the loss exceeds provisions. As a result, the implication of participation in debt reduction for funding costs could be particularly severe.
In countries where country risk provisions are normally excluded from capital, realizing a loss affects capital only to the extent that the loss exceeds provisioning levels. Thus, banks in most European countries (excluding France) would not suffer substantial erosion of capital as a result of participation in debt reduction operations; however, banks facing a high marginal tax rate and for which the spread between the costs of funding through capital and through deposits is small may find that the tax benefits of provisioning outweigh the costs in terms of capital. In these circumstances, the most profitable strategy for the bank may be to maximize tax benefits by establishing provisions in excess of the expected loss and avoid realizing losses.
Accounting and Regulatory Treatment of Debt Exchanges
Banks’ preferences between alternative forms of debt reduction are likely to be influenced by the accounting and regulatory treatment applying to these transactions and, in particular, to the new instrument obtained by the creditor in exchange for an existing claim. The key issue is the impact of the operation on the carrying value of the claim, that is, the book value net of provisions. For a buy-back operation in which the creditor receives convertible foreign exchange, this impact is easily measured as the carrying value of the original claim less the value of cash received, while rules applying to debt-equity conversions are complex but have been clarified by experience. However, for debt exchanges, the appropriate regulatory and accounting treatment is less well established and national authorities have been required to make rulings as new instruments have developed on how these instruments should be valued and on the appropriate degree of provisioning.
In most creditor countries, generally accepted accounting principles would require that a bank receiving a new instrument should book the instrument at its fair value, if it is to be held to maturity, but mark to market if it is to be placed in the trading portfolio; however, in the absence of a well-developed market for an instrument, the concept of fair value does not lead to a precise valuation. In the Mexico-Morgan exchange, most banks avoided marking down claims substantially below their carrying value, which was seen by banks as a definite advantage of the debt exchange over a buy-back where the loss would have been realized in full. Banks that wish to avoid incurring losses to regulatory capital might prefer an exchange involving a reduction in interest rather than principal, because in Japan and most European countries, such an exchange would not require any immediate reduction in the value of the claim. In the United States, FAS 15 allows banks to avoid showing an up-front loss on the transaction provided that the undiscounted sum of future cash receipts specified by the new terms exceeds the recorded investment and that the restructuring is deemed to involve only a modification of terms of the original claim. The SEC has indicated that this provision would be allowed for both the 1989 Mexico discount and par exchanges. However, it would apparently not be available for an exchange occurring through an auction, which has acted as a disincentive to the use of auctions as a “price” setting mechanism in debt exchanges.
The second factor that affects how a debt exchange affects the carrying value of the instrument is the provisioning required or expected on the new instrument. In France, Japan, and Switzerland, regulators view the need to provision primarily as a protection against loss of principal, and thus would not normally expect provisioning against a claim whose principal value was adequately secured. As a result, provisions would not be required against an instrument whose principal value was fully collateralized, such as the instrument obtained in the Mexico-Morgan exchange, while provisioning requirements would be maintained in full on instruments involving interest collateralization or guarantees but no cover of principal. In Belgium, the Netherlands, and the United States, bank supervisors look primarily at the value and security of collateral rather than how it is distributed between principal and interest payments. This “neutral” treatment has been justified on the grounds that the realizable value of an instrument depends on the security of the stream of payments to which it lays claim, not on how these payments are distributed between principal and interest.
It has been suggested that allowing banks to delay showing losses on their balance sheets implied by participation in debt reduction for a number of years may reduce significantly the effective price at which a bank would agree to participate in an exchange. This might be achieved, for example, by special accounting rules that allow participating banks to amortize the loss over a number of years, rather than having to take the loss up front, for example by application of FAS 15 in the United States. Alternatively, provisioning requirements on the new instrument could be reduced, which would serve to moderate the loss of capital suffered by participating banks in countries where provisions are excluded from capital.
The value of such “accounting or regulatory enhancement” depends critically on two factors, the cost of raising capital rather than alternative sources of funding and the tax treatment. However, provided that the cost of additional capital is limited and that tax treatment is consistent with regulatory treatment, the value of the “enhancement” would not be worth more than a few cents on the dollar off the exchange price.51 This result is consistent with analysis of the Mexico-Morgan debt exchange that shows that the effective price of debt accepted by banks in the exchange was only marginally less than the prevailing secondary market price, despite the favorable regulatory treatment of the exchange relative to a buy-back.52 Moreover, in considering such “accounting or regulatory enhancement,” the potential costs of distorting regimes intended to provide accurate information and adequate protection to the investor would need to be taken into account.
Tax Policy
Tax policy influences the degree to which realized current losses and anticipated future losses to a bank can be offset against its tax liabilities. The higher the tax relief provided on realized losses, the less is the capital cost of realizing the loss. Conversely, however, providing tax relief of anticipated future losses by allowing contributions to provisions as a tax deduction reduces the tax inducement to actually realize the loss.
Some observers have argued that measures to restrict the extent to which provisions qualify as a tax deduction would improve incentives toward debt and debt service reduction. However, restricting such deductions may be legally difficult, especially where provisions are excluded from capital or where the tax benefit has already been taken. In addition, restricting the deduction might also be undesirable from a regulatory point of view as it would increase the cost to the bank of establishing provisions at prudent levels. Thus, it may be neither practical nor desirable to attempt to restrict tax benefits on provisioning up to prudent levels.
Where a change in policy would seem more justified would be to restrict tax benefits on provisions above prudent levels. As described above, in certain circumstances, banks may see tax advantages in overprovisioning anticipated losses and avoiding recognition of the loss for as long as possible to take the maximum benefit of what is in effect an interest-free loan from the tax authorities. In a number of countries in continental Europe, tax deductible provisions have already reached high levels, and some banks may well be overprovisioned. While the authorities have attempted to restrict such overprovisioning by limiting tax benefits of provisions on a case-by-case basis, this policy is cumbersome and the process may not always lead to correct decisions. An alternative approach would be to establish that the calculation of the required tax refunds implied by overprovisioning should include a charge corresponding to the interest benefits that the banks have obtained. Such an interest charge would not penalize prudent provisioning but would serve to eliminate the incentive to overprovision. Where provisions are increasing but have not yet reached high levels, a similar result would be achieved by requiring that tax benefits from additional provisions above a certain level be placed in an escrow account, earning a market-related interest rate, which could then be allocated between the bank and the tax office when the loss is actually determined.
The size of the tax relief obtained from realizing losses will generally depend on the extent to which provisions have already qualified as tax deductions and on a range of factors including marginal tax rates, the income against which tax deductions can be applied, and the possibility of carrying the losses forward or back. In some cases, the application of these factors may provide banks with an incentive to delay realizing losses in order to maximize associated tax benefits. This seems to be the case particularly in the United States.
Increasing the tax benefit that banks receive when they realize losses clearly would increase incentives to participate in debt reduction, but major changes in tax laws designed to raise the value of tax deductions would not seem feasible in most creditor countries, for both fiscal and political reasons. Nevertheless, it may be possible to provide interpretations of existing laws that give banks greater flexibility in evaluating and using realized losses as tax deductions, so as to reduce the degree to which tax considerations limit participation in debt reduction. However, a serious problem with such proposals is that such changes might be exploited by banks to obtain tax benefits in transactions with third parties that do not in fact result in any reduction on claims on the debtor country—for example, an interbank swap of claims on different countries. In this way, creditor country governments would be making tax expenditures without reaching the desired objective of reducing the burden of debt. Moreover, banks might use the flexible treatment accorded to losses on sovereign debt as a precedent for claiming enhanced treatment on domestic losses.
For further details see Jonathan Hay and Michael Bouchet, The Tax, Accounting and Regulatory Treatment of Sovereign Debt (Washington: World Bank, 1989).
The debt reschedulings that occurred in the mid-1980s for most of the problem debtors did provide for some reduction in the spread charged over LIBOR, but these reductions were typically in the range of ½ to 1 percentage point and spreads remained positive. In general, banks were not required to revalue their claims or to increase provisions specifically as a result of these changes in interest terms. More substantial changes in terms were offered in the context of the Argentina financing package of 1987 and the Brazil package of 1988, which included provisions for banks to exchange existing claims at par for low-interest exit bonds. However, take-up was very limited in the Argentina case and while banks did subscribe to about $1 billion of exit bonds as part of the Brazilian package, most banks were looking to take advantage of the fact that these bonds could be subsequently applied in debt-equity and debt-export swaps, and thus placed the bonds in their trading portfolio at market value.
This point can be illustrated with a simple example. Consider a bank exchanging a claim with face value of 100 for a security with face value of 80 backed by secure collateral of 20. Let the market discount on uncollateralized exposure be 50 percent. Then the transaction is a fair one as the bank is exchanging a claim with market value of 50 for a security with market value of 50. Originally the bank holds provisions of 30. In making the exchange, it makes a book loss of 20, leaving provisions of 10. But to maintain the provisioning ratio against country exposure it needs provisions of 60 multiplied by 0.3, that is, 18. So the bank must raise provisions by 8.
See Charles Collyns, “The Effect of Provisioning and Debt Reduction on the Cost of Funding” (mimeographed, Washington: International Monetary Fund, 1989).
Ibid.
See David Folkerts-Landau and Carlos Alfredo Rodriguez, “Mexican Debt Exchange: Lessons and Issues,” in Jacob A. Frenkel, Michael P. Dooley, and Peter Wickham, eds., Analytical Issues in Debt (Washington: International Monetary Fund, 1989), pp. 359–71.