(Bloomberg) Warning: Banks in the U.S. are bigger than they appear.
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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., Bank of America Corp. and Wells Fargo & Co. would double in assets, while Citigroup Inc. 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 and Deutsche Bank AG, 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. 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.
JPMorgan and Citigroup
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 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.