U.S. Banks Bigger Than GDP as Accounting Rift Masks Risk
Warning: Banks in the U.S. are bigger than they appear.
That label, like a similar one on automobile side-view mirrors, might be required of the four largest U.S. lenders if Thomas Hoenig, vice chairman of the Federal Deposit Insurance Corp., has his way. Applying stricter accounting standards for derivatives and off-balance-sheet assets would make the banks twice as big as they say they are -- or about the size of the U.S. economy -- according to data compiled by Bloomberg.
“Derivatives, like loans, carry risk,” Hoenig said in an interview. “To recognize those bets on the balance sheet would give a better picture of the risk exposures that are there.”
U.S. accounting rules allow banks to record a smaller portion of their derivatives than European peers and keep most mortgage-linked bonds off their books. That can underestimate the risks firms face and affect how much capital they need.
Using international standards for derivatives and consolidating mortgage securitizations, JPMorgan Chase & Co. (JPM), Bank of America Corp. (BAC) and Wells Fargo & Co. would double in assets, while Citigroup Inc. (C) would jump 60 percent, third-quarter data show. JPMorgan would swell to $4.5 trillion from $2.3 trillion, leapfrogging London-based HSBC Holdings Plc (HSBA) and Deutsche Bank AG (DBK), each with about $2.7 trillion.
JPMorgan, Bank of America and Citigroup would become the world’s three largest banks and Wells Fargo the sixth-biggest. Their combined assets of $14.7 trillion would equal 93 percent of U.S. gross domestic product last year, the data show. Total assets of the country’s banking system would be 170 percent of economic output, still lower than 326 percent for Germany.
U.S. accounting rules for netting derivatives allow banks to erase about $4 trillion in assets, the data show. The lenders also can remove from their books most mortgages they package into securities, trimming an additional $3 trillion.
Off-balance-sheet assets and derivatives were at the root of the 2008 financial crisis. Mortgage securitizations kept off the books came back to haunt banks forced to repurchase home loans sold to special investment vehicles. The government had to rescue American International Group Inc. (AIG) with a bailout that ballooned to $182 billion after the insurer couldn’t pay banks on derivatives tied to those bonds.
Derivatives are financial contracts whose value depends on stocks, bonds, currencies or other securities. Because two parties agree to swap cash or collateral at the end of a pre-determined period, that value also depends on the existence of the counterparty when it’s time to pay.
Netting allows banks and trading partners to add up the positions they have with each other and show what would be owed if all contracts had to be settled suddenly. These master agreements are only relevant during bankruptcy and underestimate risk, according to Anat Admati, a finance professor at Stanford University. When a bank’s solvency is in doubt, derivatives partners demand to be paid immediately, causing a run.
“These liabilities do matter in times of distress,” said Admati, whose book “The Bankers’ New Clothes” was published this month. “By netting, you are hiding fragilities.”
The U.S. Financial Accounting Standards Board and the International Accounting Standards Board pledged a decade ago to converge the two bookkeeping systems. After six years of meetings, they remain divided. Proposed rules for how much money banks need to set aside for loan losses may make European and U.S. lenders even less comparable.
“Having no uniform standard is challenging for issuers and users,” said John Hitchins, head of U.K. banking and capital markets at PricewaterhouseCoopers in London. “Analysts and investors can’t compare companies’ financials across borders. Banks have to prepare multiple versions of their financial statements in different countries where they have units.”
The U.S. accounting board tightened rules on what needs to be consolidated in 2009 after the financial crisis, forcing more than $200 billion of assets onto the balance sheets of the four biggest banks. Those included most mortgage bonds not backed by the government. Untouched were about $3 trillion of securities guaranteed by U.S.-owned housing-finance companies Fannie Mae and Freddie Mac.
While the board agreed with banks that the securities didn’t need to be counted because they were insured by the government, risk returned to firms that originated the loans after the housing market collapsed. Since 2008, the four lenders have faced demands to take back $67 billion of mortgages sold to securitizations backed by Fannie Mae and Freddie Mac. They repurchased a majority of those and settled some disputes because the loans hadn’t met agency underwriting standards.
European banks sell covered bonds to finance mortgage originations and aren’t allowed under international accounting rules to move the home loans that back them off their balance sheets. Covered bonds package mortgages like securitizations, and the bonds are sold to investors. In case of bankruptcy, the mortgages that back the covered bonds are walled off from other assets of the bank and can be seized by bondholders.
Buyers of the bonds can demand that banks replace soured mortgages with performing ones, leaving the credit risk with the originator. That’s similar to buyback requests in the U.S. Executives at U.S. banks disagree, saying the securitizations pass mortgage-default risk to the government and investors, while covered bonds don’t.
During the crisis, European nations bailed out dozens of banks to prevent the collapse of the covered-bond market. That’s similar to the rescue of Fannie Mae and Freddie Mac in the U.S. and shows how both mortgage markets are government-backed, said Hans-Joachim Duebel, founder of Finpolconsult, a Berlin-based housing-finance consulting firm.
“Covered bonds are not that different from the Fannie-Freddie securitization mechanism,” Duebel said. “U.S. banks are just as liable for what they originate and sell to the agencies as Europeans are for what’s in their covered bonds.”
Canadian banks, which use international standards, aren’t allowed to move mortgages off their balance sheets, even though about 75 percent are insured by the government.
What goes on balance sheets and what’s kept off affect how much capital banks are required to have.
Capital rules are intended to limit how much borrowed money banks can use in relation to shareholder equity. The higher the ratio, the greater the probability firms will have enough capital to cover losses and stay out of bankruptcy.
The Basel Committee on Banking Supervision, which sets global standards, traditionally has based capital rules on risk-weighted assets rather than raw balance-sheet size. A simpler ratio introduced in 2010 as an additional measure to rein in risk-taking would be based on total assets.
U.S. banks have been complying with a domestic version of that ratio for the past two decades. It requires U.S. lenders to have capital equal to 4 percent of total assets as determined by U.S. accounting standards. Under that definition, JPMorgan and Citigroup, both based in New York, and Charlotte, North Carolina-based Bank of America had capital ratios of about 7 percent, while Wells Fargo’s was 9.4 percent as of Sept. 30, the most recent period for which data are available.
If the banks used international standards for derivatives and consolidated mortgage securitizations, the ratio for JPMorgan and Bank of America, the two largest U.S. lenders, would fall below 4 percent. It would be just above 4 percent for Citigroup and Wells Fargo.
That would make the biggest U.S. banks look no better capitalized, or worse, than European peers such as HSBC at 5.6 percent or France’s BNP Paribas SA (BNP) at 3.9 percent at the end of last year. It also could require them to raise more capital. Spokesmen for all four banks declined to comment.
The accounting differences colored the debate in Basel when a similar ratio was introduced. U.S. regulators on the committee, which includes banking supervisors from 27 nations, at first proposed adopting international rules for netting derivatives when calculating the simpler capital standard, also called a leverage ratio.
European regulators would only agree if the ratio were set no higher than 1 percent, according to former FDIC Chairman Sheila Bair, who participated in the talks. Instead, the committee opted to use U.S. accounting rules for netting derivatives and set the limit at 3 percent.
A 3 percent ratio means that a bank needs $3 of capital for every $100 of assets. For the more traditional Basel capital measure, the same $3 would result in a higher ratio because some of the assets are discounted by the smaller amount of risks they are assumed to carry.
“The U.S. leverage ratio doesn’t capture off-balance-sheet risks,” said Bair, now chairman of the Systemic Risk Council, a private regulatory watchdog. “Once U.S. banks start publishing the new Basel-mandated ratios, more off-balance-sheet assets will become obvious.”
Bair said she favors raising the simple capital ratio as high as 8 percent. Hoenig, the FDIC vice chairman, has called for 10 percent. U.S. regulators are still debating how to implement the rules. Because Basel isn’t an international treaty, each country needs to adopt its own version.
Still, the European Union is balking at implementing the capital rule based on total assets. It’s considering delaying when EU banks have to begin reporting the ratio using the methodology and hasn’t decided whether to make it binding.
The first Basel rules were agreed to in 1988 in an effort to converge global banking regulations. Fourteen years later, U.S. and international rule-setters signed what is known as the Norwalk agreement, named after the Connecticut town where the U.S. accounting board is based, pledging to work together to “make their existing financial reporting standards fully compatible as soon as is practicable.”
Behind the initial push were David Tweedie, the first chairman of the International Accounting Standards Board; Harvey Pitt, who headed the U.S. Securities and Exchange Commission at the time; and Paul Volcker, the former Federal Reserve chairman instrumental in the group’s formation.
Progress on common standards slowed after Mary Schapiro became SEC chairman in 2009 and faced lobbying by companies opposed to what they said would be costly accounting changes, according to four people with knowledge of the discussions who asked not to be identified because the talks were private.
“I’ve always supported working toward convergence, and we pushed FASB and IASB hard to reach satisfactory agreements,” Schapiro, who left the SEC in December, said in an interview. “But I wasn’t keen on dropping the U.S. accounting standard and adopting the international one before those differences were significantly narrowed.”
In 2011, the U.S. accounting board came close to moving in Europe’s direction on derivatives netting. There was pushback from the largest U.S. banks, according to a person familiar with the talks. Lenders argued that gross values overstate actual positions because parties often make opposite bets rather than tear up existing contracts. The board dropped the plan.
Tweedie, a former chairman of the U.K.’s accounting board, failed to win the support of France and Germany for convergence, according to the people familiar with those discussions. While European banks have long favored the U.S. approach to netting derivatives, they haven’t pushed for change because it wouldn’t have an impact on income statements or capital requirements, which are based on risk-weighting of assets, according to Andrew Spooner, a London-based partner at Deloitte LLP.
“When it’s about the size of the balance sheet only, and not a profit-loss issue, it’s not as crucial for firms,” Spooner said.
New disclosure requirements for U.S. and European banks on how they net derivatives that take effect this year will make comparisons easier, Spooner said. The biggest U.S. banks already are reporting more details in the footnotes of quarterly financial statements, making it possible to calculate their derivatives assets under international standards.
There isn’t as much uniformity in disclosures of off-balance-sheet assets. JPMorgan’s securitizations of home loans backed by Fannie Mae and Freddie Mac were estimated by using the figure for mortgages the bank services and the average ratio of servicing to off-balance-sheet assets at other lenders.
U.S. rule-setters have done more than their international counterparts to force banks to consolidate securitization vehicles. Still, there was little debate about whether lenders should include loans sold to Fannie Mae and Freddie Mac.
Before the financial crisis, the government-backed firms didn’t include mortgage bonds created from those loans on their balance sheets either. After collapsing under the weight of losses and being taken over by the government, both Fannie Mae and Freddie Mac started consolidating the securities. They also tried to recover losses from banks that sold them badly underwritten home loans.
Lenders have said improved control mechanisms for loans they originate and transfer to Fannie Mae and Freddie Mac for packaging into mortgage bonds obviate the need to consolidate or set aside reserves for future repurchases. That optimism isn’t shared by Esther Mills, president of Accounting Policy Plus, a New York-based consulting firm.
“There was clearly a failure by certain institutions to appropriately assess the liabilities before the crisis,” said Mills, a former Morgan Stanley (MS) and Merrill Lynch & Co. accounting executive. “Are there enough liabilities going forward for the billions of mortgages being transferred?”
In the first nine months of last year, San Francisco-based Wells Fargo transferred $398 billion of mortgages to residential-mortgage securitizations guaranteed by Fannie Mae and Freddie Mac. The bank recorded a $209 million liability for “probable repurchase losses,” according to its latest quarterly filing. It has faced more than $12 billion of buyback demands from the government-backed firms for crisis loans.
“There are probably some dangerous things left off the balance sheet still, and we’ll only find out what in the next crisis,” said David Sherman, an accounting professor at Northeastern University in Boston. “But how many times do we have to go through this to figure it all out?”
After failing to agree on common standards for derivatives netting and consolidation of securitizations, rule-setters are now heading in different directions as they debate how to account for loan-loss reserves.
The U.S. accounting board proposed after the financial crisis that banks mark all loans and debt securities to market values, not just those held short-term. The board abandoned the plan after lobbying by banks, which would have had to recognize losses, according to a person familiar with the deliberations.
A new U.S. proposal that would require banks to record expected losses over the lifetime of a loan has met with similar opposition. The plan would force lenders to set aside higher reserves upfront, leading to lower profits than European peers, Sherman estimates.
Under current accounting rules on both sides of the Atlantic, only incurred losses need to be reported. The international board is considering a change that would require banks to reserve for losses expected over a 12-month period.
While both the U.S. and international proposals probably would result in higher loan-loss reserves, they might not prevent lenders from being too late recognizing losses, as they were in the past, according to Jamie Mayer, a bank-accounting analyst at Grant Thornton LLP in Chicago.
“If their risk models don’t show any problems, and they didn’t before 2008, it’s unclear how solely changing the accounting would solve concerns,” Mayer said in an interview.
In a January survey of 70 banks around the world conducted by auditing firm Deloitte, 88 percent of respondents said they don’t expect convergence on accounting rules most relevant to lenders, including derivatives, balance-sheet consolidation and how to reserve for loan losses.
Leslie Seidman, chairman of the U.S. accounting board, and Hans Hoogervorst, head of the international panel, both said at a conference in New York last month that they hadn’t given up.
“I still hope for one standard,” Hoogervorst said. “But at times it’s easy to be discouraged.”
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