Is the banking system healthy?

The Washington Post carried an article in which it asked the question of is the banking system healthy and then tried to explain why it is despite the fact that bank stocks trade at depressed levels.

Regular readers know that in the absence of banks providing ultra transparency and disclosing their current global asset, liability and off-balance sheet exposure details, it is impossible to tell if the banks are healthy.

What is known is that financial regulators suspended mark to market accounting and engaged in regulatory forbearance that allows the banks to engage in 'extend and pretend' and transform non-performing loans to 'zombie' loans.

The fact that neither of these policies have been reversed and the banks don't voluntarily provide ultra transparency suggests the banks are hiding massive amounts of losses.

In addition, as the article notes, the banks have tremendous potential for litigation related losses.  Despite a number of get out of jail free cards from the Obama Administration, see mortgage servicing and mortgage backed securities, there are numerous other examples of bad bank behavior, like manipulating Libor, that could give rise to losses that render the banks insolvent/needing to be closed.

On paper, the nation’s banks are making a comeback: More money is being set aside in case of trouble, there are fewer losses on loans and there is less reliance on volatile funding. 

What has happened on paper has been incredibly good for the bankers in terms of the bonuses that they have received.

Put that is only on paper that is easily manipulated by both the banks and their regulators to provide the impression of financial health when in fact the bank could be insolvent (see all the EU banks that failed shortly after the regulators pronounced them well-capitalized as a result of a stress test).

Too bad the markets don’t seem to care.

The market aren't fooled by paper.

One of the reasons that nobody is fooled is that each of the banks knows how much it is hiding in the way of losses on its balance sheet as a result of regulatory forbearance and suspension of mark to market accounting.

Another reason that the market is not fooled is that banks with deposits to lend know that in the absence of ultra transparency they cannot evaluate the solvency and risk of banks that are looking to borrow.  As a result, the unsecured interbank lending market remains frozen.  This is a red flag!

Despite the strides banks have made to repair their balance sheets since the financial crisis, their stocks are trading below book value. Wall Street remains skeptical about the overall health of these institutions, even as profits have soared in the past year. 

But why? 

“Investors expect more losses ahead,” said Mark Williams, a former bank examiner who teaches finance at Boston University. “Many of these banks still have loans that could go bad if the economy goes south.”...

Investors know that with current disclosure practices the banks are black boxes that cannot be evaluated.  Investors cannot determine how many zombie loans a bank has or make an estimate how many loans will go bad if the economy goes south.

What investors do know is the fact that banks refuse to provide ultra transparency so investors can answer these questions.  This is a big red flag that banks have something to hide.

The largest banks have also been engulfed in a sea of litigation with no clear end in sight, Williams said. Dozens of cases brought by investors who claim they were misled about securities deals are still winding through the courts. 

Meanwhile, prosecutors have yet to reach agreements with many of the banks, including JPMorgan Chase, Bank of America and Citigroup, being investigated for manipulating the global interest rate known as Libor. Resolution of these investigations could take another year at least, placing an ominous cloud over some of the nation’s largest institutions. 

Regulators, nonetheless, are encouraged by gains in the banking system that point to continued improvement of a once beleaguered industry. 

Testifying before the Senate Banking Committee last week, Thomas Curry, the comptroller of the currency, said conditions at the more than 1,800 banks his agency supervises continue to improve.

One of the problems that led to the financial crisis was bank regulators making misleading statements about the financial condition of the banks.

Mr. Curry's commets are an example of this.  Investors know that the banks could all be insolvent and Mr. Curry would be saying that their condition is improving as conveying the true financial condition of the banks violates the principle of say nothing bad about the banks for fear of risking the safety and soundness of the financial system.

The way to end the regulators saying anything about the banks is to require the banks to provide ultra transparency.  Then there is no reason for the regulators to offer an opinion as market participants can assess the solvency and risk of each bank for themselves.

“The banking system is arguably as strong as it has ever been,” Mark Zandi, Moody’s Analytics chief economist, said. “Capital is at record levels, and there is ample liquidity. Credit quality is good and improving rapidly.”

The counter argument could also be made:  the banking system has never been weaker as low interest rates are reducing bank net interest margins and earnings, credit quality continues to deteriorate as unemployment rates remain at elevated levels, and bank book capital has no basis in reality as a result of suspension of mark to market accounting and regulatory forbearance.