Before the emergence of capital markets and their enabling technologies, the market standing of a bank could be roughly inferred from the assets and liabilities recorded on its balance sheet.

Such inferences today, however, can be quite misleading. The reason? More and more of a modern bank's profitable activities are not represented on its balance sheet at all!

The one hard clue to this immense shift of strategic focus lies in the rising contribution of noninterest income to the revenue stream of leading banks, often 40% (and more) of their operating income.

Unfortunately, given the inertia of bank financial reporting practices, the sources of this income are only spottily disclosed.

Worse, the even slower rulemaking process in accountancy is based on very ancient and deeply embedded axioms as to what assets and liabilities are recordable (everything else being nonrecordable -- that is, off balance sheet).

The adverse consequences of this myopia are several.

Public policy toward banks -- to say nothing of the public perception of banks is distorted. Bank capital regulation, already illogical, becomes more so.

Enterprise-descriptive accountancy is thwarted, and investors in bank securities wind up playing with less than a full deck of data.

Even the chairman of the Federal Reserve Board has recently been seen in print mourning the steady erosion of bank loans and deposits relative to total financings and savings.

This may be true (and probably is) for the U.S. banking system as a whole. But how can we rely on such analysis if the off-balance-sheet volumes of securitized loans are ignored, to say nothing of savings controlled by banks in the form of off-balance-sheet mutual fund assets and annuities sold to bank customers?

To put it another way, the "business velocity" of aggressive banks today can no longer be measured by the size and growth of their balance sheets. The surgeon general should probably require warning labels.

But let's go beyond these simple examples of substitution (among which should also be included loan commitments and standby letters of credit) to categorize the total off-balance-sheet role of banks.

The full range includes:

* Asset-postponement products (notably loan commitments and letters of credit).

* Asset management (personal and institutional trusts, mutual funds, and securitized pools).

* Asset servicing (for example, mortgages, master trust and custody).

* Risk-management products ("derivatives") and associated trading portfolios.

* Payment-system services (notably, cash management, securities portfolios, and ATM networks).

The reality is that the leading edge of the banking industry has rather rapidly reinvented itself in order to participate in the post-1980 explosion of capital markets, here and around the world.

To be sure, not many banks know how to fish in these turbulent waters, where the rate of product mutation is notoriously high. But some do. These in turn are rapidly setting a new pattern.

The day may come when "net interest income" -- the backbone of basic banking -- comes to be called "nonfee income" at banks where fees contribute over half of operating income!

Capital Ratios

The linchpin of the FDIC Improvement Act of 1991 is a set of three capital ratios that purport to measure the soundness of individual banks.

Since the risk measurement concepts underlying these ratios were silly or obsolete years before this legislation carved them in stone, the further strategic evolution of banks will render them even more irrelevant.

Our argument, we hasten to add, is not that more capital is needed to support the newer activities of banks. It is that the governmental measurement system is flawed in its very theory of risk, to say nothing of the arbitrary computation thereof.

What is beginning to happen instead is that the private-sector practice of risk management is coming to ignore (except for compliance purposes) the shackles of the 1991 law in or follow the lead of pioneers like Bankers Trust, whose system of integrating risk, pricing, and capital has revolutionized not only the theory but the practice of capital adequacy determination.

Crucial Omission

The baggage of existing rules and the glacial slowness of rulemaking in accounting virtually guarantee a continuing commitment to the primacy of disclosing assets (what we own) and liabilities (what we owe).

The problem, in a nutshell, is that the assets representing a bank's commitment to postpone, manage, service, synthesize, or transfer financial assets are nothing but contracts -- and the rules say that contracts, no matter how economically valuable, have zero statement value unless purchased.

To put this another way, the "historic cost" basis of asset determination is able to assign value only to an asset whose cost is documentable.

To illustrate, a chair, represented by its bill-of-sale, is a recordable asset, but a contract to manage money does not have identifiable development costs, and therefore has no asset value.

The same contract, however, sold to another bank, has an asset value -- namely, the cost of purchasing the contract. This cost, moreover, includes the buyer's estimate of intangible asset value -- that is, the often high potential for future profits based on the longevity of client relationships.

For all but the most expert users of bank financial statements, therefore, these ancient axioms spell a deepening information blackout as more and more activities of banks are conducted off balance sheet.

To be sure, off-balance-sheet products are subject to audit (we like to believe). But these receive only scattered notice in footnotes, with no linkage to revenue and no overall kinship diagram.

The blackout is deeper to the extent that substantial intangibles are buried therein.

Financial Reporting

Our one ray of hope is that the less rule-bound cousin of accounting we call "financial reporting" is free to publicize useful supplementary data that go unrecognized within the temple of the certified financials.

How does this work? Much financial reporting is discretionary -- for example, disclosure and discussion of the total of managed credit card receivables, on and off balance sheet (the best way to describe overall portfolio performance).

Useful as this occasional sunshine may be, it is not customary disclosure, and thus the opportunity for comparison is limited.

Enter the Securities and Exchange Commission, which has developed a series of "guides" mandating supplementary disclosure in several industries.

Guide 3 (the most extensive of the seven) mandates rather a lot of "nonstatement" disclosure by publicly held bank holding companies.

Developed in 1976 and based largely on the advice of a task force of bank stock analysts, Guide 3 has begun to show its age. It fails completely to address the post-1980 financial products that are so large a part of bigger banks' strategy.

Accordingly, the SEC has recently determined to revise the guide, again welcoming the recommendations of analysts.

The imminent revision of Guide 3, which the SEC wants to implement as soon as possible, could be momentous.

In the Dark

Even if the truly expert among bank stock and debt analysts knew all about off-balance-sheet product families and the associated income (they don't), the same couldn't be said for:

* Portfolio managers (for whom bank stock is typically less than 5% of a stock portfolio).

* Buy-side analysts (who nowadays cover at least several industries.

* Retail brokers (whose vast knowledge tends to be two inches deep).

* Individual investors.

For these users of financial information, the balance sheet continues to loom large in any discussion of investment opportunities.

And for them the only evidence of the existence and profitability of off-balance-sheet products is just a one-liner in the income statement: "noninterest income."

To be sure, some very superficial breakout of this income by type is to be found in annual and quarterly reports.

Since this income often exceeds 40% of total operating income, has not the time finally come for analysis and investors to pierce its veil?

The first fruits of this effort would be the beginning of understanding and comparison. The second result would be the asking of good questions. And the third, and most important, will be a surer basis for assessing the value of bank securities.

Degrees of 'Assetness'

To visualize a proposed off-balance-sheet disclosure scheme by product type, associated asset volumes, and revenues, imagine a series of five concentric circles with a sphere at the center. The ordering of these rings is based on their closeness to "assetness."

* The inner sphere represents the recorded assets, liabilities, and capital of a banking company, on a generally accepted accounting principles basis.

* The first outer circle represents the potential future assets of a bank, in the form o commitments and standby letters of credit.

* The second circle summarizes the various assets that a bank manages under contract: securitized pools, personal and institutional trusts, and mutual funds.

* The third ring contains the asset volumes serviced under contract: mortgages, securities in custody, trusteed student loans, and master trust agreements covering pension assets.

* In fourth place is the circle containing derivatives, that is, instruments that reshape the risk profile of an underlying instrument, whether for sale to others, for "own account" risk management, or for "own account" profit seeking. (We are assuming here that associated trading portfolios -- such as foreign exchange -- are booked as recorded assets.)

* The outermost ring includes financial transfers for third parties: securities clearance, cash management, money transfer, and ATM/ACH operation.

Spreadsheet Disclosure

What should usefully be disclosed about these categories? To begin to answer this question, let's set aside the "concentric rings" image in favor of standard spreadsheet disclosure.

Each major category (postponed assets, managed assets, and so on) should be further subdivided as indicated above, even though this means putting trust products (like money management and custody) alongside bank products (like credit card portfolios and mortgage servicing).

The first three major categories should throw off asset volume and revenue information by major subtype. In the case of credit card and other loan securitizations, there should also be "memo" disclosure that sums the assets under management, whether booked or not.

The final two categories, those most removed from "assetness," do not lend themselves to asset disclosure, for two reasons.

First, trading portfolios are already recorded.

Second, derivative volumes are meaningless when shown gross, since it is their "netted" relationships to one another (and to assets) that measure their significance. However, their revenue production is disclosable.

The sum of revenue from all off-balance-sheet products should then correspond to total noninterest income except for (a) fees and products generated from recorded assets and liabilities and (b) fees generated from the sale of third-party contracts, such as externally-managed mutual funds and annuities.

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