Banks, Disclosure, and Reform

Bankers can’t have it both ways. Either they are going to have to honestly disclose their positions or they are going to face more and more intrusion into their operations.

The honesty factor is a concern if banks continue to publically lie about their balance sheet positions. I have written about this before in my May 5 post “Can the Financial System Still be Trusted”, http://seekingalpha.com/article/203077-can-the-financial-system-still-be-trusted. Others are providing clearer evidence of this behavior. See the Wall Street Journal of May 26, “Banks Trim Debt, Obscuring Risks”, http://online.wsj.com/article/SB20001424052748704792104575264731572977378.html#mod=todays_us_front_section. The Journal followed this with another on May 27, “BofA, Citi Made ‘Repos’ Errors” http://online.wsj.com/article/SB10001424052748704032704575268902274399416.html#mod=todays_us_money_and_investing.

If banks want our trust, they are going to have to be honest with us.

The disclosure factor I am referring to pertains to mark-to-market accounting. The Financial Accounting Standards Board has proposed that commercial banks mark the value of their loan portfolios to “fair value” standards. Banks already use mark-to-market accounting for other assets on their balance sheets, although they basically don’t like this requirement.

The general argument provided by the bankers is that this mark-to-market requirement would require banks to take “big losses” on loans during certain periods of economic distress and this “could” be misleading because the loans “would probably still pay off over time” This analysis is from today’s New York Times: http://www.nytimes.com/2010/05/27/business/27fasb.html?ref=todayspaper.

This argument infuriates me. I have been the President and CEO of two financial institutions and the CFO of a third, all publically traded companies, and if I have heard this argument one time I have heard it a thousand times. And, in most cases, the statement has referred to loans that eventually were written down or written off.

The argument, ironically, is not applied to the loans that do perform! My experience is that the claim is a defensive statement from a loan officer or bank executive that is overly sensitive to the fact that they have not performed and don’t want this fact publically recognized.

I would add two things to this discussion. First, when loans start to go bad, a good management should want to identify the problems as soon as possible so that they can do something about them. Postponing dealing with loans that are experiencing some trouble can only lead to more trouble in the future. Well run institutions are ones that deal with their problems “up front” and do not try and hide them in the hopes that they will go away.

Second, bankers take risks: credit risk, interest rate risk, liquidity risk, leverage risk, and other forms of risk. This is their job. But, there is a cost of taking risk. As we have seen from the recent financial buildup and collapse, during periods of credit inflation, asset bubbles, and other cases of excess, bankers push the edge taking on more credit risk, more interest rate risk, more leverage risk, and so on.

In order to maintain our trust in banks and the banking system we need to know what the banks have done and how their decisions have affected the value of the assets on their balance sheets.

“Critics of applying fair value to loans have said the existing use of fair value has deepened the financial crisis by forcing financial firms to take unjustified losses on assets that shrank in value when market conditions worsened temporarily.” (See http://online.wsj.com/article/SB20001424052748704032704575268962900687370.html#mod=todays_us_money_and_investing.)

Come on, be big boys and girls. You made the decisions! Accept the consequences of those decisions!

In terms of financial reform, I am more in favor of using “early warning” systems like the one recently proposed by Oliver Hart and Luigi Zingales in the journal National Affairs , http://nationalaffairs.com/publications/detail/curbing-risk-on-wall-street, and “To Regulate Finance, Try the Market” in Foreign Policy, http://experts.foreignpolicy.com/blog/5478. But, to go this route, financial institutions should be open to full disclosure and accounting transparency. I will write more on the Hart/Zingales approach in the near future.

I happen to believe that this kind of behavior, the encouragement of openness and transparency, represents good management practices. (See my post “On Audits and Auditors”, http://seekingalpha.com/article/195594-on-audits-and-auditors.) Using a sports analogy again: good teams and good players do not rely on trickery…they just outperform other teams and players that have to use deceit and deception to try and get the upper hand!

Good managers and good managements are not afraid of “the open air”!

The alternative is for there to be more explicit attempts to regulate and control the financial institutions. Going this direction ultimately fails (see my post “The ‘Sound and Fury’ of Banking Reform”, http://seekingalpha.com/article/206341-the-sound-and-fury-of-banking-reform) but it is time consuming, expensive and inconvenient in the process. And, choosing this path leads to ‘cat-and-mouse’ games that do not contribute to increasing the public’s faith and trust in the banking system and the regulators.

This seems to be one of the major problems of modern America. In my memory, there was a time when we could have faith and trust in our business and financial institutions and in our government and in each other. This ‘faith and trust’ is sorely missing now. It would be nice if some leaders appeared that actually tried to restore these characteristics to our national life. I just don’t see any of this kind of leadership on the horizon.

In my mind, banks need to take a leadership position on the “Disclosure” process and assume a stance that is more disciplined than would be imposed by any regulatory standard. In doing this they would take control of the issue.

Or, they must accept the lack of faith and lack of trust that follows a government-led effort to constrain and control them. They cannot fight disclosure and fight greater government oversight at the same time.