Monday, September 24, 2012

Determining the true size of megabanks is impossible

In his Wall Street Journal Heard on the Street column, David Reilly focuses on what should be a simple question to answer:  what is the true size of the megabanks.  His answer:  we don't know.

This is a problem.

Disregarding the actual risks of the megabank's exposures, how can you do a back of the envelope analysis to determine if the accounting construct known as bank capital is appropriately sized if you don't know the true size of the megabucks?

Regular readers know that determining the risk of a megabank and the adequacy of its capital requires the bank to provide ultra transparency and disclose on an ongoing basis its current asset, liability and off-balance sheet exposure details.

With this information, market participants can easily calculate the true size of the megabanks.

More importantly, with this information, market participants can independently assess the risk of the megabanks.  With this assessment, market participants can adjust the price and amount of their exposure to these banks.

By adjusting their exposure, market participants can exert discipline on the banks to restrain, if not reduce, their risk.

Does J.P. Morgan Chase JPM -0.90% have $2.3 trillion in assets, $4 trillion or perhaps somewhere in between? 
Just how big the biggest U.S. bank is depends on your view of how derivatives should be accounted for on banks' books. And the potentially huge difference in size shows why simplifying bank regulation is anything but easy. 
In recent weeks, Thomas Hoenig, a director at the Federal Deposit Insurance Corp., and Andrew Haldane, executive director for financial stability at the Bank of England, have decried the additional complexity of postcrisis regulations. Both urged more reliance on simpler measures that avoid distortions caused by risk-weighting assets as called for under new iterations of Basel capital rules....
The simplest solution is ultra transparency.

It eliminates all distortions caused by risk-weighting assets and lets market participants determine for themselves if they think a bank is adequately capitalized.
Risk-weighting of assets is indeed a problem. Banks will base some weightings, which influence capital needs, on complex, internal models. Such weightings also incent banks to hold supposedly risk-free debt, such as government bonds, which the European crisis has shown can actually be quite risky. 
Risk-weighting of assets is subject to gaming by banks.

Ultra transparency is not subject to gaming.
The trouble is, even clearer-cut measures of tangible equity and leverage aren't always straightforward. While both depend on measures of assets that aren't affected by risk weighting, the size of those assets can vary greatly due to the treatment of derivatives. 
Under U.S. accounting rules, banks offset many derivative holdings against others to come up with a net asset number. So while J.P. Morgan reports $1.7 trillion in gross derivative assets in notes to its financial statements, it includes just $85.5 billion on its balance sheet. 
International rules require banks to show gross derivative values on their balance sheet with less netting allowed. That makes European banks appear larger than they would under U.S. rules. 
This all makes it tough for investors to compare the leverage employed by different international banks. It may also mask the dangers posed by derivatives to individual firms or the wider financial system....
Please re-read the highlighted text as Mr. Reilly makes the argument for why we need ultra transparency as it allows investors to compare the leverage at different international banks and, perhaps more importantly, allows investors to assess the dangers posed by derivatives at each firm and across the financial system.
For investors still shaken by the balance-sheet implosions of the financial crisis, this is another reminder they can't take any number for granted—even when dealing with something as basic as assets.
Ultimately, the fact that investors cannot take something as basis as the calculation of total assets for granted highlights why we need ultra transparency.

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