Mar 15, 2013

Hidden Numbers Make Banks Even Bigger



It sounds like a simple question. How big is that bank? But it is not. Under American accounting rules, banks that trade a lot of derivatives can keep literally trillions of dollars in assets and liabilities off their balance sheets. Since 2009, they have at least been required to make disclosures about how large those amounts are, but the disclosures leave out some things and — amazingly enough — in some cases do not seem to add up.



The international accounting rules are different. They also allow some assets to vanish, but not nearly as many. As a result, it is virtually impossible to confidently declare how a particular European bank compares in size with an American bank. Much of that will change when first-quarter financial statements start coming off the printing presses in a few weeks. For the first time, European and American banks are supposed to have comparable disclosures regarding assets. Their balance sheets will still be radically different, but for those who care, the comparison will be possible. This comes to mind because these days it seems that big banks do not much want to be thought of that way. A rather angry argument has broken out regarding whether “too big to fail” institutions get what amounts to a subsidy from investor confidence that no matter what else happens, they would not be allowed to fail. The banks deny it all. Subsidy? Penalty is more like it, they say. We’ll get back to that argument in a moment. But first, there is some evidence that the big American banks may have scaled back their derivatives positions last year. At five of six major financial institutions, the amount of assets kept off the balance sheet appears to be lower at the end of 2012 than it was a year earlier. Still, the numbers are big. JPMorgan Chase, the biggest American institution, had $2.4 trillion in assets on its balance sheet at the end of 2012. But it has derivatives with a market value of an additional $1.5 trillion that it does not show on its balance sheet, down from $1.7 trillion a year earlier. So is JPMorgan getting bigger? Measured by assets on the balance sheet, the answer is yes. That total was up $93 billion from 2011. But after adjusting for the hidden assets, the bank appears to have shrunk by $109 billion last year. If the bank used international accounting rules, it appears it would be getting smaller. Not having those assets on the balance sheet makes the bank look less leveraged than it might otherwise appear to be. If you simply compare the book value of the bank with its assets, it appears it has $11.56 in assets for every dollar in equity. Add in those derivatives, and the figure leaps to $18.95. It is not as if those assets are not real, or that they are perfectly offset by liabilities also kept off the balance sheet. There is a similar amount of liabilities that are not shown, but there is no way to know just how they match up with the assets in terms of riskiness. The nature of derivatives makes it hard to assess aggregate totals. If a bank has a $1 million loan to someone, that is an asset that would go on the balance sheet at $1 million. Presumably the worst that could happen is that the bank would lose the entire amount. But a large derivative position might currently have a market value of $1 million, and thus would be shown as being worth the same amount, whether on or off the balance sheet. But if the market moves sharply, the profit or loss could be many multiples of that figure. Under American accounting rules, banks that deal in derivatives can net out most of their exposure by offsetting the assets against the liabilities. They do this based not on the nature of the asset or liability, but on the identity of the institution on the other side of the trade — the counterparty, in market lingo. The logic of this has to do with what would happen in a bankruptcy. What are called “netting agreements” allow only the net value to be claimed in case of a failure. So the bank shows the sum of those net positions with each party. But those positions are not offsetting in terms of risk, or at least there is no way to know if they are. The figures shown in the financial statements and footnotes simply describe market values on the day of the balance sheet. If prices move the wrong way, as asset can turn into a liability, or a liability can become much larger. And both can happen at the same time. The asset might be an interest rate swap, while the liability is a wheat future. Obviously, they are not particularly likely to move in tandem. To return to JPMorgan, on its balance sheet are derivative assets of $75 billion, and derivative liabilities of $71 billion. Neither number is very large relative to the size of the bank, and you might think that swings in values would be unlikely to be very large. But those numbers are $1.5 trillion smaller than the actual totals. Obviously, the swings on a portfolio of that size could be much larger. A few years ago, the accounting rule makers set out to get rid of the netting, and make balance sheets more accurate. But there were complaints from banks and others, and the American rule makers at the Financial Accounting Standards Board concluded that was not a good idea. So there is still netting in the United States. Some of it, involving repos and reverse repos, is not disclosed at all now, but will be when the new rules kick in. The sort-of invisible derivative assets and liabilities are only part of the reason that it is so hard to really get a handle on just how risky any given bank is. Regulators look at banks’ “Tier 1 capital ratios,” in which they divide capital by “risk-weighted assets.” They get high numbers. But Thomas Hoenig, the vice chairman of the Federal Deposit Insurance Corporation — which will be on the hook if a bank fails — sees problems with both parts of that ratio. He says that risk weightings can be misleading and that capital includes some intangible things — such as deferred tax assets — that would be of no use in a crisis. He prepared a table, based on midyear numbers, that asserts that banks are a lot riskier than they appear. At Bank of America, which had a Tier 1 capital ratio of 13.8 percent, he calculated a ratio of tangible equity to tangible assets, including the derivatives, and got a figure of 3.4 percent. “Banks,” he said in an interview, “are riskier than what the Tier 1 capital ratio would have you believe.” He added that after adjustments are made, it becomes clear that “smaller banks hold much higher capital.” Smaller banks, in general, have little in the way of derivative positions. Wells Fargo is unusual in being big and not having a huge derivatives portfolio. (It also is unusual in that its disclosures do not make clear just how large the amounts are that are hidden, as do those of most other banks, although the numbers are clearly relatively small.) That brings us back to the question of whether there are still “too big to fail” institutions, and what advantages they have. The Dodd-Frank law tried to make sure there would be no more such banks by requiring that systemically important financial institutions — now known as SIFIs — have plans to wind up their operations without requiring a bailout to protect the system. Opinions vary as to whether that would work in a new crisis. Two senators who want to keep any bank from being too large — Sherrod Brown, a Democrat from Ohio, and David Vitter, a Republican from Louisiana — have asked the Government Accountability Office to study whether big banks get an effective subsidy because investors think they are too big to be allowed to fail, and therefore are willing to accept lower interest rates. Some research by economists has put that advantage as high as 80 basis points, while other research has come up with lower figures. This week Wall Street fired back. A group of financial industry associations released a paper arguing the advantage was much smaller, and might not exist at all now that Dodd-Frank is the law. “Just last week,” the paper said, “Standard & Poor’s issued a briefing that concludes that investors are now imposing a funding premium of 35 basis points on large banking companies.” That was a bit misleading. The S.&P. video compared big banks to similarly rated large industrial companies, not to small banks, and suggested the difference might reflect fears of rating downgrades at the banks. It is interesting that the big banks like to have financial statements that make them look smaller than they are, and vigorously dispute the idea there is a financial advantage to being big. Perhaps they protest too much. By FLOYD NORRIS nytimes.com