Contingent claims separate revenue and cost into two different time periods. Revenue comes in the initial origination process, while the cost comes upon completion of the contract in the event of default. With banks increasing contingent claims in recent years, a higher taxable income leads to a shift in a bank's balance sheet toward tax-free income and tax-shielding liabilities. This provides a valuable case-study of corporate finance theories of tax management. This paper builds a model to illustrate the income features of contingent claims. Call Reports from 1990–1996 are examined, and show significant evidence of increases in leverage associated with contingent claims.
Since Modigliani and Miller (1958) and Miller's (1977) subsequent work detailing the irrelevancy of how investments are financed, much effort has been devoted to finding the optimal corporate debt level. Moreover, since interest paid for debt service is tax deductible, much attention is paid in this area to tax management. DeAngelo and Masulis (1980), in “Optimal Capital Structure Under Corporate and Personal Taxation,” theoretically determine the optimal capital structure with regards to taxes. This optimal capital structure balances the tax deductibility benefits of debt with bankruptcy costs and competing tax shields.
It has been difficult, however, to find unambiguous empirical evidence of tax management by firms. Recent studies have made progress in isolating the tax effects by examining how changes in the leverage decision, rather than the aggregate level of debt, are associated with changes in tax shields.
One branch of the empirical literature (e.g. MacKie-Mason, 1990) focuses on detecting cross-sectional differences in the marginal tax rate. Shevlin (1990) and Graham (1996) explicitly calculate an expected marginal tax rate in the presence of tax shields to get a simulated marginal tax rate. This simulated marginal tax rate reflects the present-discounted tax cost of earning one more dollar in the present period. Using panel data, Graham (1996) finds that higher marginal tax rates are correlated with greater changes in the proportion of debt financing. This is consistent with the use of debt for tax benefits.
Another branch of analysis uses changes in the tax code as a natural experiment to see how firm financing and asset choices change. Givoly, Hayn, Ofer, and Sarig (1992) study the leverage changes after the Tax Reform Act of 1986. Scholes, Wilson, and Wolfson (1990) deal explicitly with tax planning by commercial banks in the context of changing regulations on the deductibility of municipal bond interest.
This paper is a combination of the two branches. First, I analyze cross-sectional differences in the use of contingent claims versus taxable income and tax shields. Also, regulatory changes in the past two decades have allowed contingent claims to be used more frequently by banks. Finally, looking at a source of income to the bank is a cleaner experiment empirically than examining a particular tax shield that could either substitute or compliment other tax shields.
Off-balance sheet financial instruments are particularly interesting empirically considering their use has been rising since the early 1980s. One measure of off-balance sheet activities used is non-interest income since there is no explicit record of the transactions on the balance sheet. Contingent liabilities, a specific form of off-balance sheet loan, are reported by commercial banks on the Report of Condition and Income (Call Report). Table 1 shows that one type of contingent claim, loan commitments, has been rising dramatically as a proportion of bank assets even in the period subsequent to Boyd and Gertler (1995).
Table 1.
Trend in contingent claims written by U.S. banks
Year Letters of credit / assets Commitments / assets Proportion reporting letters of credit Proportion reporting loan commitments Return to assets
1990 0.0044 0.0544 0.7374 0.8076 0.0019
1991 0.0042 0.0614 0.7493 0.8363 0.0025
1992 0.0040 0.0682 0.7647 0.8645 0.0032
1993 0.0041 0.0774 0.7795 0.8882 0.0034
1994 0.0043 0.0869 0.7904 0.9123 0.0034
1995 0.0043 0.2982 0.7966 0.9275 0.0039
1996 0.0043 0.1871 0.8033 0.9403 0.0039
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Not only has the average proportion of contingent claims risen in the past decade, but the number of banks participating in these markets has also risen. Table 1 also reports the proportion of banks (from a sample of 9525 commercial banks from the Call Report) which reported either letters of credit or loan commitments in each year. As the table shows, the proportion issuing letters of credit has risen almost 7 percentage points (629 banks), and the proportion issuing loan commitments has risen over 13 percentage points (1267 banks).
With an increase in loan commitments, banks are increasing current income from writing the commitments, but the expenses are coming from past commitments. Banks are therefore increasing current taxable income. This increases the attractiveness of tax shields, as I show in the model below, since the marginal tax rate is potentially higher. Off-balance sheet activities would therefore have an effect on the balance sheet of the bank. The next section models the relationship between contingent claims and taxable income.
