Regular readers know that the questions surrounding how the credit derivatives positions were accounted for highlight the need to require banks to provide ultra transparency.
By making the banks disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details, market participants aren't reliant on the bank's "accounting". Rather, market participants can value the positions for themselves and determine the true financial condition of the bank.
Accounting experts say Deutsche Bank appears to have improperly accounted for billions of dollars of credit derivatives trades by failing to value adequately the risk that its trading counterparties could walk away.
The Financial Times reported this month that US regulators were examining claims from three former Deutsche employees who have accused the bank of failing to recognise $4bn-$12bn in paper losses on complex derivatives, known as leveraged super seniors, with a notional value of $130bn.
The trades involved Deutsche buying credit protection from investors on highly-rated corporate debt. When the financial crisis hit in 2007, the value of this insurance increased and Deutsche booked profits. But the complainants argue that it failed to properly account for the risk of its counterparties walking away from the trade rather than paying out on the insurance – known as “gap risk” – which rose along with the value of the insurance and could have led to big losses.
Charles Mulford, accounting professor at Georgia Tech business school, said: “I believe that the gap risk should have been adjusted to market value – consistent with the views of the former employees,” adding: “One cannot mark-to-market the upside but not the downside.”
The bank does not dispute that it booked profits by marking-to-market the protection but argues it did nothing wrong in not marking-to-market the gap risk. ...