Regulatory Capital Planning and Deferred Tax Assets in a Post-Financial Crisis Environment

Abstract

In this study we examine the role of accounting discretion in calculating regulatory capital in financial institutions by specifically examining deferred tax assets (DTAs). We use the insurance industry as our setting as regulators substantially relaxed rules relating to DTA inclusion in regulatory capital calculations during and following the financial crisis. Many DTAs depend upon future taxable income for realization, making them less liquid relative to other assets. We examine whether firms use the increased discretion in regulation to increase the proportion of their regulatory capital relating to DTAs and find evidence that they do so. As DTAs are less liquid relative to other assets, our study raises the concern that financial institutions may appear more financially stable than the reality of their underlying economic condition. Consistent with this concern, we find firms with relatively low levels of regulatory capital included higher levels of DTAs in their regulatory capital calculations relative to their peers. We also document that higher levels of DTAs are associated with a higher likelihood of insolvency and ratings agencies are not incorporating DTAs into their life insurer rating criteria. Our study has important implications for regulators considering changes to capital standards for other financial institutions.

Keywords: Deferred Tax Assets, Regulatory Capital, Insurance, Ratings, Regulation

JEL Classification: G18, G22, H25, M41, M48