Monday, April 13, 2009

Bank Accounting - Rules or Reality?

The U.S. accounting authorities are finishing a round of changes to the way banks account for the value of their impaired assets. A number of rules are involved: FAS 114, FAS 115, FAS 124, FAS 157. The combined effect will make it easier for banks to avoid reporting losses on their loan portfolios.

There's been a lot of discontent among analysts and in the press about the changes. Critics complain that the new rules make it easier for banks to overstate their capital. The Wall Street Journal warned about "a loophole big enough to fit a bloated bank balance sheet through ("Accounting Rules Should Avoid Impairment," April 1, 2009)."

The article accuses the rule makers of allowing a kind of capital arbitrage, where banks keep losses out of regulatory capital but include them in regular shareholders' equity. That's not the case. The new rules will let the banks keep some losses on the fair value of assets out of earnings, but not out of capital or shareholders' equity.

Whatever the accounting technicalities, the economic reality of bank capital is difficult to analyze. The regulatory concept of Tier 1 and Tier 2 capital is complex and impossible to verify directly from a bank's balance sheet. Analysts have to rely on the bank's calculations for those measures.

That's why analysts are beginning to favor a simpler measure: tangible equity capital, often abbreviated as TEC. TEC is shareholders equity less intangible assets, both as reported on the balance sheet. Divide that into total assets to get the TEC ratio, a direct, efficient measure of a bank's capital position.

Let's see how it works on a real bank, PNC Financial Services Group.

The emerging standard for an adequately capitalized bank is a TEC ratio of at least 4%. PNC's Tier 1 ratios are much higher than its TEC ratios, but the bank still meets the TEC capital standard -- as long as you ignore the fair value of its loan portfolio.

In 2008, PNC had $2.95 billion in unrealized losses on its loans.
Under the fair value rules, those losses would still be unrealized as long as the bank treats them as assets held to maturity. But PNC is required to disclose those losses in the notes to its financial statements. If we take them into account and use adjusted ratios, both PNC's ratios fall, and its capital doesn't look so healthy.

Financial reporting is loaded with confusion and uncertainty, and never more than when the rules are changing. Financial analysis is a struggle against the darkness with a set of imperfect tools. When the rules are changing and key measures aren't working anymore, it's still possible to get at the economic reality by trying new measures and making thoughtful adjustments.

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