Way banks account for losses highlights need for ultra transparency

The more that is written about whether or not Deutsche Bank concealed $12 billion in losses and whether or not this was done with the blessing of BaFin, the German bank regulatory, the clearer it becomes that banks need to be required to provide ultra transparency so market participants can know what is actually go on with each bank.

In an editorial, the Financial Times looks at the way that banks account for losses.

In recent decades, such optionality as they once enjoyed has been steadily circumscribed. 

Most trading assets – such as the “leveraged super-senior” derivatives at the heart of the complaint – must now be marked to market. This has reduced banks’ ability to manipulate their balance sheets. Deutsche’s approach, it is claimed, drove a coach and horses through this principle. 

Like many market-makers in derivatives the bank sat in the middle of two notionally hedged flows of payments. The snag was that in this case the positions did not wholly mirror each other. Deutsche faced a particular risk that in certain circumstances, it might face big losses on one of the trades. Rather than account for this gap as it yawned during the crisis, the allegation is that the bank failed to account for it. 

There is a strong argument for giving banks leeway in marking losses to market at times of stress. During the crisis, for instance, the market for some complex financial products simply froze. Confronted with the losses, and likely meltdowns, that would have flowed from marking such assets to zero, regulators sensibly allowed banks to fall back on reasonable estimates of intrinsic worth.

This is an argument that the bankers would have you believe.

It rests on one critical assumption:   bank on and off-balance sheet exposures are shrouded in opacity.

If banks are required to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details, then there is absolutely no reason to provide banks any leeway in marking losses to market as recognizing losses that market participants already know exist is not going to lead to financial contagion and meltdowns.

Regular readers know that with ultra transparency market participants can independently value each bank's exposures for themselves or hire third party experts who can.  Market participants do this as part of assessing the risk of each bank.

Then, and this is very important, market participants adjust their exposure to each bank based on the combination of their assessment of the risk of each bank and the market participant's capacity to absorb losses given this level of risk.

Bottom line, with ultra transparency, market participants limit their losses to what they can afford to lose.  By doing this, they effectively end financial contagion.

Regular readers also know that the reason that markets for complex financial products and interbank lending froze is nobody could assess whether the counter-party was solvent or not.  Requiring the banks to provide ultra transparency unfreezes and keeps unfrozen these markets.

Finally, when regulators allow banks to manipulate their balance sheets by marking the bank's exposures to its estimate of intrinsic worth, the regulators render bank book capital levels meaningless.  Everyone knows the banks cannot sell their exposures at these lofty valuations and as a result, bank book capital levels are grossly overstated.

But this is a world away from simply fudging losses out of existence.

Banks are used to fudging losses out of existence with their regulator's blessing.  This is called regulatory forbearance.  A well known example is all the bad debt that through the practice of 'extend and pretend' has been turned into 'zombie loans'.

The Securities and Exchange Commission, which is investigating the claims, has yet to decide whether to act. It may be tempted to let sleeping dogs lie as the positions have now mostly been liquidated, and it is claimed that the German regulator may even have let Deutsche account for the derivatives as it saw fit.

This would be a mistake if Deutsche does indeed have a case to answer.

If the SEC accepts the argument about letting sleeping dogs lie as the positions have now mostly been liquidated, it is shirking its primary responsibility.

The SEC's primary mission is to ensure that market participants have access to all the useful, relevant information in an appropriate, timely manner for making a fully informed investment decision.

As Deutsche demonstrates, current bank disclosure rules are inadequate. The SEC doesn't need to punish Deutsche, it just needs to require banks provide ultra transparency so that this can never happen again.

While there is an argument for forbearance at times of stress, this must be and proportionate.

No there isn't.  It creates problems without solving any problems.

Banks should not be gifted the option of deciding what losses to declare. That would simply encourage the accumulation of more assets that are hard to value and vulnerable to crises. 

This is the last thing the world needs.

Which is why it is necessary that banks be required to provide ultra transparency.

With ultra transparency, market discipline is exerted on banks to recognize all of their losses.

With ultra transparency, market discipline is exerted on banks to reduce their exposure to hard to value assets that are vulnerable to a crisis.  Market discipline will take the form of a higher cost of funding and lower stock price for riskier banks.