Regulation: Enhanced disclosures are a big step forward

By:
Peter Lee
Published on:

Bank accounting fails to convey a true picture of the risks banks take and that is why adopting the task force’s recommendations is so important.

In a speech in November on the challenge of assessing capital requirements for UK banks, Andrew Bailey, managing director of the Prudential Business Unit of the Financial Services Authority (FSA), outlined some of the difficult judgements regulators have to make.

Chief among these is the uncertainty around the quality of a number of asset classes on bank balance sheets and their valuations, and of determining the true scale and nature of loan forbearance.

Bailey told his audience that UK regulators know that loan forbearance is quite widespread.

The Financial Policy Committee (FPC) of the Bank of England flagged the same issue in September, blaming the difficulty banks have had in following its instructions to raise new equity capital from the markets on investors’ uncertainty about valuations of assets on their balance sheets.

The FPC has told the FSA to make sure banks improve their provisioning practices and mark assets properly.

Regulators, falling short of claiming a systemic problem in the UK banking system, and almost with a nod and a wink, are simply asserting that banks play fast and loose with valuations. Come on: we all know it goes on.

Investors were hardly surprised when successive interventions by Spanish policymakers earlier this year forced that country’s banks gradually to come clean about the true extent of losses on various classes of real-estate loans.

Also in November, Fitch reminded investors that temporary forbearance measures enacted in Japan in 2009 to ease financing for small and medium-sized enterprises, and which allowed rescheduled loans still to be classed as performing, have probably masked the build-up of credit risk inside Japan’s regional banks.

Christian Stracke, managing director at Pimco, notes eloquently that while many banks have gone to considerable lengths in recent years to disclose more information about their risks, the fact remains that investors tend to see banks as opaque black boxes where risks are still poorly disclosed or – worse – actively obscured by management.

Industrial companies might be complicated, but their risks in general can be readily understood. In the case of a bank, however, both bond and equity investors often have great difficulty knowing precisely what they are investing in.

It is this widespread mistrust and assumption of the worst that inspired the Financial Stability Board’s Mark Carney to invite banks and investors to sit round a table and hammer out a solution between them.

He extended that invitation in May. At the end of October, the Enhanced Disclosure Task Force (EDTF) announced more than 30 recommendations, covering all the hot-button issues that have worried investors about bank reporting: forbearance on non-performing loans (NPLs); surprisingly generous calculation of risk-weighted assets through banks’ self-certified internal models; and poor disclosure over the extent of encumbrance of so-called liquid assets that might not be much use in a liquidity crisis.

It is an important document that comes with suggested formats for banks to tabulate information on key risks. It recommends banks describe the policies for identifying impaired or NPLs, including how the bank defines impaired or non-performing, restructured and returned-to-performing (cured) loans, as well as explanations of loan-forbearance policies.

It has plenty of recommendations on clearer, more consistent presentation of RWAs and the key-inputs in models to calculate them, as well as on presentation of liquidity and funding risk.

Libraries full of earnest, well-meaning, best-practice recommendations are pouring forth every day alongside urgent regulatory demands. Do not make the mistake of ignoring this one. It is a valiant effort to tackle an issue so big that regulators scarcely dare admit to it: the way banks account for their balance sheets and profit and loss fails comprehensively to convey a true picture of the risks they take.

How can a little heard of division inside the best-regarded bank in America suddenly burst into investors’ consciousness through the admission of multi-billion-dollar losses from risk trades no one seemed to know were even being put on?

Investors do not want reports that comply with regulations by disclosing a key number on, say, page 131, which if they could only link in with a pertinent fact in the footnotes on page 407, might deliver a valuable hint as to what is really going on. Only lawyers have time for this game: they charge by the hour anyway.

Stracke from Pimco co-chaired the EDTF, alongside Russell Picot, general accounting officer of HSBC, and Hugo Bänziger, former chief risk officer at Deutsche Bank. It is impressive that the task force reported so quickly. It is important that banks and investors produced it together. Many in the markets have called on investors rather than regulators to set the agenda in governance of the financial institutions. They have finally stepped forward here.

Banks in a sound position will have more incentive to disclose a true and clear picture of their risks than banks still muddling through and hoping for the best. However, there will be consequences in loss of debt and equity capital markets access if some banks ignore these recommendations while others comply.