For the Banks, Mark-to-Market Accounting Dies Again!

“Strategic vision of financial executives on how to generate economic performance while controlling risk is likely to become a differentiating factor, a determinant of not only success but of the very economic viability of financial institutions in the changed world. Have leading financial firms and institutional investors come to the same conclusion?”

This is from the book “Financial Darwinism” by Leo Tilman.( http://seekingalpha.com/article/221607-making-money-in-the-21st-century-financial-darwinism-create-value-or-self-destruct-in-a-world-of-risk-by-leo-tilman)

The banking industry has provided an answer and the answer is “No!”

The banks have beaten down the accounting industry: “Banks Force Retreat on Fair-Value Plan” is the title in the print edition of the January 26, 2011 Wall Street Journal; “Retreat on ‘Marking to Market’” is the title in the electronic edition. (http://professional.wsj.com/article/SB10001424052748704013604576104012708309774.html?mod=ITP_moneyandinvesting_1&mg=reno-wsj)

“Accounting rule makers, bowing to an intense lobbying campaign, took a key step Tuesday to reverse a controversial proposal that would have required banks to use market prices rather than cost in order to value the loans they hold on their balance sheets.

The debate over the proposal is the latest chapter in a battle pitting investors who wanted better disclosure of the value of bank’s assets against the banks themselves. Banks have argued against so-called fair-value accounting, saying market prices would have left them at the mercy of volatile markets and could have caused additional strain during the financial crisis.”

The banking industry is still back in the middle ages. And, this is just what Tilman is arguing about.

To Tilman, the “golden age” of banking was when commercial banks worked with a “Static Model” of banking. Banks lived off the “carry trade”: because of highly restricted and regulated banking markets, banks operated in quasi-monopoly positions where they could earn relatively high returns on the loans they made and pay zero or close to zero on the deposits they attracted, providing them with a “lusty” net interest margin (NIM). Their model was static because they could originate loans or buy securities and hold them until they matured. Marking to market was not an issue. Credit risk was the only real risk bank lenders had to be worried about.

Today a “Dynamic Model” of banking exists and the transition to this dynamic model was horrendous. The “buy and hold” strategy could no longer work. In the late 1960s, interest rates began to rise. In the 1970s, declining NIMs became a major problem and the banks countered the declining margins by moving into fee income. In the 1980s all hell broke loose as NIMs practically vanished and banks began diversifying into other assets in order to generate returns that justified their existence.

Banks did not adjust their thinking in terms of risk management during this time period. As Tilman describes in his book, as commercial banks moved into Principal Investments (α-type investments) and investments exhibiting Systematic Risks (β-type investments) their risk management knowledge and skills lagged far behind the dynamic changes that were taking place in financial markets.

On top of this commercial banks continued to add leverage to their balance sheets as a means of generating another 5 or 10 basis points or more to their return on equity.

When the cookie began to crumble, it became obvious that financial institutions had mis-managed their risk exposure and had leveraged-up to such a degree that there was little or no way to keep the cookie together. The industry had to be bailed out.

In the modern world where the “Dynamic Model” of financial management rules, the “buy-and-hold” philosophy that applied to the “Static Model” of banking is legacy.

By getting rid of “Mark-to-Market” the banking industry is kidding itself and just setting itself
up for future trauma. It is hiding its head in the sand and pretending that the world has not changed.

The world has changed. Net interest margins are not what they once were. Buy-and-hold policies are not realistic. And financial leverage is going to be more severely regulated. So who is going to manage risk if it is hidden on the balance sheet?

My advice to bank managements: mark your portfolios to market. You don’t have to, but, for once, “get real.” If you are going to buy risky long term investments…accept the fact that they are subject to interest rate risk…and credit risk. You don’t get the return unless you assume something to justify the extra return. Who are you fooling by not marking-them-to-market? You are only kidding yourselves.

Tilman argues that generating “economic performance while controlling risk” is going to be “a differentiating factor”, a determinant of success but also of the economic viability” of a financial institution.

In the 1950s and 1960s banking was a very quiet and stable environment. The industry did not attract the “best and the brightest.” There was the joke around Philadelphia that in wealthy families that had three sons, the smartest became a doctor, the next smartest became a lawyer: the dumbest became a banker.

The thrift industry was even worse. Tilman titles his book “Financial Darwinism.” In the case of survival, most thrift managements were awful, much worse than bank managements, and, the thrift industry is dead,! Are the smaller commercial banks the next in line for extinction?

When I joined the Finance Department at the Wharton School, UPENN, (in 1972) "Finance" did not have a course on the financial management of commercial banks. (I did create that course while I was there.) The reason why no bank management course existed was that the big banks, City, Morgan, Chase, and so on, did not recruit students at Wharton. They recruited from the history department, the literature department, and so forth…well, they really recruited from the social clubs, the tennis team, and the golf team. They wanted people who could socialize with customers and get along with them at the highest social levels. They didn’t want some sharp intellect that was quantitatively orientated to work in “their shop.”

Bankers have never liked uncomfortable situations. They have been notorious for keeping bad loans on their books until they absolutely have to charge them off. They are also notorious for refusing to acknowledge that some of their assets might be “under-water”. Bankers are notorious as risk managers.

Risk management is going to be a major differentiator of bank performance in the future. We have seen how inadequate risk management can help the industry self-destruct. Anyone investing in banks…or regulating banks…should pay special attention to how a management recognizes risk; the policies and procedures it puts in place to manage risk; and the efforts it makes to disclose to people the value of the assets the bank has on its balance sheet.

The banking industry is changing. I have just written up my view of some of the changes that are coming (See http://seekingalpha.com/article/247809-banking-is-changing-look-out-for-opportunities) Good risk management is going to be a “decider” of who survives

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.