The EU is collecting evidence to determine if Greece, Portugal, Spain and Italy should face an investigation into whether they are illegally underwriting banks that have bolstered their capital with assets considered low-grade in the rest of the eurozone.

At issue are so-called deferred tax assets, which are accepted as core capital in the four southern European countries, but which are not regarded by the European Central Bank as "high quality".

A full probe by Brussels into the legality of the way that governments guarantee these assets would pose a severe challenge for southern European banking systems that are still struggling to recover from the eurozone crisis.

Any withdrawal of government support for deferred tax assets could dramatically weaken some banks’ capital buffers, raising the spectre of another shock to Europe’s banks.

The European Commission is currently studying information requested from member states to establish whether the case merits a formal investigation. People familiar with the process said a "conversation" was now under way between member states and competition authorities in Brussels.

Greece is a particular worry for regulators as Athens says deferred tax assets represent some 30 to 40 per cent of the core tier one capital in the country’s main banks. Overall, the four countries hold more than €40bn in deferred tax assets as core capital in their banking systems, according to ECB data published last October.

Deferred tax assets are created when banks make losses that they can later offset against their tax bill. Under the Basel III rules on bank capital, such assets will progressively no longer count as bona fide capital. But the four southern European states have classified them so that they do still count.

The case has come into the sights of competition authorities in Brussels because they investigate arrangements that they suspect are illegal “state aid”. In this case, the question of unfair state support arises because Madrid, Lisbon, Rome and Athens would have to back up the capital composed of tax credits if the banks were to collapse.

The request for information comes with the ECB launching a big clampdown on national exceptions to capital rules. Danièle Nouy, the eurozone’s chief banking supervisor, told the Financial Times in February that there were “too many national options in the definition of capital in Europe and we have to address that”.

To compensate for the perceived weakness of deferred tax assets, the ECB has signalled that it would increase capital buffers, called Pillar 2 requirements, on banks seen as over-reliant on this kind of capital. The commission’s powers can be stronger, however. Declaring state guarantees illegal would rob the capital of its value.

Margrethe Vestager, EU competition commissioner, said in an interview with the Financial Times last month that she and her team had not "made up our minds at all" about whether there would be a formal investigation into deferred tax assets.

Nicolas Véron, senior fellow at the Bruegel think-tank, said that the key question determining whether the commission would launch formal action would be “whether the tax advantage resulting from the deferred tax assets is specific to the banking sector or whether it is sufficiently spread out across sectors to be considered a general tax measure.

“If an overwhelming share of the aggregate tax advantage goes to banks, then deferred tax assets may be considered state aid.”

In addition to the commission's groundwork, one official also added that the European Banking Authority, an EU agency, had also started work on whether deferred tax assets were creating an uneven playing field in Europe.

The Greek, Spanish, Portuguese and Italian governments all declined to comment.

– (The Financial Times Limited 2015)