Ignorance isn't bliss for banks

In his Wall Street Journal Heard on the Street column, David Reilly looks at accounting games banks play to maintain the facade that they are healthier than they really are and why this renders bank capital meaningless.

He concludes that investors and other market participants need a current view of each bank's condition.

Regular readers know that this current view is ultra transparency under which the banks disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

The only thing worse than a big loss at a bank is pretending it doesn't exist. 

With regulatory forbearance, this is true of banks in the EU, Japan, the UK and US [I left China off the list, but it probably should be on the list too].

Many financial firms discovered this the hard way during the financial crisis. By ignoring losses, they dug themselves into ever-deeper holes.

Despite that, many banks now want regulators to allow them to again bury their heads in the financial sand....

Actually, they turn to the financial regulators and got mark-to-market accounting suspended and regulatory forbearance so they could engage in 'extend and pretend' with their bad debt.

One result of this is that no one can tell if a bank is solvent or not (see:  conclusion of Financial Crisis Inquiry Commission).  Since they cannot tell if a borrowing bank is solvent or not, banks with deposits to lend don't lend and the unsecured interbank lending market is frozen.

Another result is that the burden of the excess debt in the financial system has been shifted onto the real economy with the result being a Japan-style economic slump as capital is diverted from reinvestment and growth of the real economy into debt service payments.

Bank regulators last week said they would hold off on finalizing the rules, known as Basel III, until sometime next year....

The Independent Community Bankers of America, a trade association, already has called on regulators to exempt banks with less than $50 billion in assets from the new rules or, failing that, some parts of them. 

Among these: a requirement that banks include in their calculations of capital unrealized gains and losses on securities they hold. The argument is that including these will subject capital ratios to unnecessary volatility. This is because the banks say they intend to hold the securities in most cases to maturity, so the losses won't actually hit them. 

But as many banks learned during the financial crisis, market storms have a way of swamping intentions. A bank facing a funding crunch may be forced to sell holdings, and recognize losses, even if it didn't originally plan to do so. 

Since banks borrow funds on a short-term basis to lend them out for longer periods, it is imperative for investors and regulators to have a current view of what such assets are worth. 

Please re-read the highlighted text as it summarizes why banks must be required to provide ultra transparency.

That is especially the case with securities, because these tend to have ready market values, unlike the loans banks hold on their balance sheets. 

Current rules don't require gains and losses on such holdings to be included in capital, although they affect a bank's book value. The crisis showed the flaw in this as investors lost faith in capital ratios partly because they excluded such losses. 

Also, banks have long argued that their loan books shouldn't be marked to market prices because loss reserves are created against these holdings.

Investors understand that excluding losses on securities makes bank capital completely meaningless.  In addition, loss reserves are subject to manipulation as a result of the combination of regulatory forbearance and 'extend and pretend' -- turning a bad loan into a 'zombie' loan saves the banks from writing off the loan and having to replenish the loan loss reserve.

That isn't the case with investment securities, making it even more dubious to try to ignore even short-term, unrealized losses. 

The issue of how to treat these gains and losses is of particular importance today. With banks awash with deposits and loan growth still tepid, their holdings of securities have been rising. ...

Superlow interest rates make this even more of an issue, as when rates eventually rise some banks could be caught holding low-yielding securities that show losses. This will especially be the case if some banks are today investing in ever-longer-dated securities to counter pressure on their net-interest margins. 

Knowing that this could have capital consequences is one way to instill market discipline. 

Aside from that, capital ratios need to reflect the risks banks have taken. Otherwise investors will find new reason to doubt their usefulness or the case for buying bank stocks.