Friday, June 22, 2012

Games played with capital ratios demonstrate why ultra transparency required

The Wall Street Journal carried an article describing how EU banks are playing games with their capital ratios to try to give the impression they are financially stronger than they really are.

Regular readers know that bank capital and any ratio that includes it are, in the words of the OECD, meaningless.

This is the direct result of the adoption of the Japanese model for handling a bank solvency led financial crisis.  Under this model, bank book capital levels are protected at all costs.  This includes bailouts and regulatory forbearance that allows the banks to keep zombie borrowers alive used 'extend and pretend' practices.

Having said that, the article is interesting as it discusses some of the games banks play to boost both bank capital and bank capital ratios.

Eliminating these games is yet another reason that banks should be required to provide ultra transparency and disclose on an on-going basis their current asset, liability and off-balance sheet exposure details.  With this information, if market participants want to, they can calculate capital ratios for each bank.
Regulators and investors are concerned that some European banks are artificially boosting a key measure of their financial health, a worry that is further eroding market confidence in the Continent's banks. 
Such concerns have been building up for more than a year. But they have intensified lately, with a parade of banks announcing that they intend to increase their capital ratios—a key gauge of their abilities to absorb future losses—partly by tinkering with the way they assess the riskiness of their assets....
At issue is the way banks calculate and disclose their capital ratios. The ratios are comprised of certain types of equity expressed as a percentage of the bank's "risk-weighted assets"—a fuzzy measure that an increasing number of regulators and investors fear is subject to abuse by banks. 
The idea behind assessing capital as a proportion of risk-weighted assets is that not all assets are created equal. A bond issued by a blue-chip company is presumably less likely to incur losses than a mortgage to a heavily indebted homeowner.... But banks enjoy wide discretion in how they assign weightings to different assets. If banks deem certain assets to be low-risk, that shrinks the denominator of the ratio and has the effect of boosting the banks' capital ratios. 
A growing body of research by regulators, analysts and other experts indicates that the practice is conducted inconsistently among different banks and different countries and is potentially prone to manipulation. 
I am 'shocked' to hear that capital ratios are being manipulated.
Pressure is mounting to use a standardized method of setting the risk weightings..... 
Relying on risk weightings "is like asking your children to grade their own homework," said James Ferguson, a strategist at Westhouse Securities in London. "It's crucial that nothing has gone wrong with these calculations, or we're in trouble." 
With regulatory forbearance and lack of mark-to-market accounting, we are in trouble.
The current "approach undermines confidence in the system, and this forces investors to require that banks hold more capital," said Richard Black, a fund manager at Legal & General Investment Management in London. 
It is the lack of transparency that undermines confidence.  If market participants had access to all the useful, relevant information under ultra transparency, they could calculate a bank's true capital and capital ratio by backing out any games the bank plays.

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