Thursday, July 11, 2013

NY Times, Financial Times & Bloomberg confirm bank capital is easily manipulated, meaningless accounting construct

To the sounds of academics economists calling for banks to hold more capital, the Fed and FDIC adopted simple bank leverage ratios to complement/strengthen the existing Basel Committee risk weighted capital ratios.

In response to this regulatory action, the NY Times, the Financial Times and Bloomberg called into question all the fuss being made by the economists by carrying articles that confirmed that bank capital is an easily manipulated, meaningless accounting construct.

The NY Times' Dealbook carried an article that attempted to answer the questions what is bank capital anyway and why is it important.
Think about capital this way: It designates the percentage of assets that a bank can stand to lose without becoming insolvent. 
If a bank’s assets decline in value, it has to account for that by adjusting the source of financing that it used. Liabilities like debt and deposits can’t be reduced, as they represent money that the bank has promised to pay to bondholders or depositors. 
But what’s useful about capital is that it can be reduced, or written down. 
That’s the whole point. Shareholders, who contribute to capital, agree to absorb losses if the bank falls on hard times. 
So, rather than a “rainy day fund,” capital is a measure of a bank’s potential to absorb losses.
The article highlights that bank book capital is an accounting construct.

Shareholders, who buy shares from the bank, contribute to the bank book capital level.  Bank book capital levels increase as a result of earnings less any dividend payments.  Bank book capital levels also decrease when the value of the bank's assets is written down (something that both banks and their regulators control through suspension of mark-to-market accounting and regulatory forbearance/'extend and pretend').

The article also defines insolvency for a bank, when its book capital level is zero or less, and leaves the reader with the impression that something really bad occurs should a bank become insolvent.

However, the article doesn't answer the question of what really bad thing happens.

The simple answer is that nothing really bad happens if a bank becomes insolvent.

Please re-read the simple answer again because a modern banking system is designed to achieve exactly this outcome.

A modern banking system can do this because of the combination of deposit insurance and access to central bank funding.  With deposit insurance, the taxpayers effectively become the bank's silent equity partners when the bank are insolvent (whether or not this insolvency is reflected in the bank's book capital level).  As a result, not only are there not runs on the banks by those covered by deposit insurance, but the bank can continue to operate and support the real economy.

The Financial Times carried an article that described how easily manipulated capital ratios are.  Banks have a number games they can play with their assets so as to maximize their reported capital ratios under either the simple leverage or risk-weighted capital ratios.
US banks believe they will be able to meet a new regulatory requirement on debt levels by shuffling assets between their subsidiaries and using other “optimisation” strategies to reduce the amount of leverage they report.... 
Analysts at Goldman Sachs noted in research for clients that “banks have a lot of options to mitigate the impact” – including moving assets, shortening the duration of derivatives and reducing credit commitments. 
Some of those steps would have the effect of reducing banks’ overall credit exposures but others would not – calling into question the robustness of a rule that is supposed to be difficult to evade.
Bloomberg carried an article on Deutsche Bank that discussed how the bank took the idea of playing with their assets to maximize their reported capital to new heights when it structured lending transactions so that they would have no balance sheet impact. 

Deutsche Bank relied on what it called “no-balance-sheet usage” to keep loans off its books, documents for the Monte Paschi and Banco do Brasil deals show.... 
In the no-balance-sheet transactions, Deutsche Bank received the collateral, sold it and used the cash to make the loan. By selling the collateral -- government bonds, in the deals reviewed by Bloomberg News -- Deutsche Bank created an obligation to return the securities, allowing it to net to essentially zero its assets and liabilities, the documents show. 
The lender in effect created a short position on the bonds, according to deal memos and internal e-mails about the transactions. In a short sale, traders sell borrowed securities and expect to buy them back at a lower price before returning them to the owner.

Deutsche Bank was able to sell the collateral because it didn’t have to return the bonds under the terms of the agreement. Instead, the borrower agreed that Deutsche Bank could return the “cheapest-to-deliver” equivalent in the event of default, the documents show. 
The German lender sold insurance against possible defaults of securities linked to the collateral, in effect moving the risk that the loan wouldn’t be repaid onto its trading book and away from public scrutiny, according to accountants who reviewed the documents for Bloomberg News.

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