The banking industry's reception of FAS 115, the Financial Accounting Standards Board guideline for market valuation of securities, has been at best unenthusiastic.
The recurring theme of our industry's most prominent leaders is that this change is another example of more regulatory interference, with no foreseeable economic benefit.
Contrary to the dominant industry view, FAS 115 is a watershed event in the history of bank investment management. It will enable banks to further enhance portfolio returns and increase liquidity while reducing overall risk.
How is this possible? The process of forcing banks out from behind the veil of book value accounting will require management to reassess its traditional approach to portfolio activities.
FAS 115 represents the elimination of the banking industry's singular barrier to the implementation of modern portfolio management concepts.
Implicit in mark-to-market accounting is performance measurement on a risk-adjusted, total-return basis, which has long been the standard in the investment industry.
Although the ability to measure bank portfolio performance on a total-return basis has existed since 1984, it has been largely ignored by the industry because of its perceived irrelevance under book value accounting.
With FAS 115, not only is its relevance absolute, but bank portfolio managers will now be evaluated on the same basis as every other fixed-income manager in the world. How will banks stack up? If recent history is any indication, the opportunities for improverment are significant.
Worse than Treasuries
Over the five-year period ended March 31, about 70% of the banks in this country underperformed the constant maturity U.S. Treasury curve.
The CMT curve performance could have been replicated by simply buying and selling a given U.S. Treasury maturity at each auction - a purely mechanical management strategy that requires no particular investment expertise.
Banks at the lower end of the industry performance range could have added as much as 250 basis points to annualized return by simply matching this performance benchmark.
The reason for this subpar performance lies in the traditional approach to bank portfolio management, which has been largely a liquidity-driven function. The security selection process was for the most part rcactive. Security sales were rare except for liquidity purposes.
A comprehensive portfolio strategy was typically nonexistent or essentially passive in nature. Because book-value accounting placed an overemphasis on yield, accountability for risk was generally lacking.
For the first time, FAS 115 brings the economics of investment risk into proper accounting perspective. Portfolio risk will be tied directly to volatility, which will ultimately be reflected in either current earnings or capital, or both. Therein lies the essential challenge facing the traditional approach to bank investing.
A New Reality
Historically, volatility has been distasteful to banks because it was typically the result of poor credit decision-making. In the modern banking world, portfolio volatility will not be something to be minimized or avoided per se, but rather a critical factor to be managed.
The challenge will be to maximize the portfolio return for the particular level of risk that is appropriate for a bank to assume.
That proper risk level will be determined by asset/liability matching needs, capital constraints, and other balance sheet risk considerations.
Test of Management
In this new environment, bank management will ultimately be judged on the real economic values that are either being carried or destroyed within their portfolios, after full consideration of risk and return.
The fixed-income market today bears only a faint resemblance to that of just 10 years ago. As the complexity of the market has expanded exponentially, so too have the number of ways risk can be assumed in a bank portfolio. As the opportunities for reward have increased, the possibilities for loss have risen accordingly.
Paralleling the explosion in complexity is the issue of competition. Stepping onto this modern playing field requires a major commitment of resources.
A dedicated portfolio manager, research staff, and information hardware are all required to compete effectively in this arena - all predicated on the assumption that the manager possesses value-adding ability.
Simply stated, financial markets have evolved into markets in knowledge. With most banks holding 35% to 40% of their earning assets in the portfolio, there is absolutely no substitute for experience, knowledge, and technical expertise in the management of those assets.
With market value accounting, mistakes can no longer be swept under the rug.
As the industry faces even greater competition from nontraditional sources, bankers must be willing to consider nontraditional responses. The opportunities presented by active portfolio management are real and significant.
However, they can only be pursued using an intelligent, conservative protocol, under a proven management discipline that places an overweighting on the evaluation of risk and the immediate responsiveness to control it.
The data define the opportunity. Over much of the industry, the need for more professional management of portfolio assets is both demonstrated as shareholders and depositors continue to seek out more competitive returns.
The chains of book value accounting have broken. The path to active portfolio management has been cleared. FAS 115 only be viewed as a major step forward in the evolution banking.