What Bank Earnings Coverage Should Focus On
Banks are likely to protest new Basel rules that would require them to hold more capital against their exposure to central counterparties, but the standard is necessary to prevent the fast-growing counterparties from becoming "too big to fail."
Regulators should demand more derivatives disclosures in forthcoming living wills. Having banks disclose the risk factors in their risk measurement models would help regulators understand if banks are well capitalized for unexpected losses.
A House subcommittee is set to discuss whether U.S. financial reform impedes our ability to compete with firms overseas. But if they were truly worried about global competitiveness, there are other, more pressing issues lawmakers should be analyzing.
Lack of bank transparency makes it difficult to see the extent of bank exposures to emerging markets and whether financial firms are adequately capitalized to withstand unexpected losses from this market turmoil or any other.
Every quarter, pundits breathlessly try to analyze how shareholders will react to bank earnings. However, it would be far more useful for the media to analyze whether the information we are getting from banks indicates they are strong enough to survive a market shock without a government bailout.
Just recently at the Office of the Comptroller of the Currency's 150th Anniversary symposium, former Federal Deposit Insurance Corp. chair Sheila Bair stated "not enough attention is placed on bank transparency." Unfortunately, almost seven years since the global financial crisis started, she is right. There are three different types of disclosures that need to be improved significantly: financial, regulatory capital and bank resolution process.
Financial disclosures are the ones with which market participants and the media are most familiar. In the U.S., the Securities and Exchange Commission is the primary regulatory that dictates the financial information banks should disclose. Yet, for all intent and purposes, the SEC has not updated its requirements in over five decades, despite how much banks especially large ones have changed since the 1980s.
In a very useful Standard & Poor's report, the rating agency stated that banks' public financial disclosure could be improved greatly in the areas including "loan loss reserves by category, assumptions behind loan reserve calculations and loss estimation, loan-to-value ratios for real estate portfolios, refreshed data on troubled debt restructurings, consistent value-at-risk disclosure, and investment portfolio details." Additionally, it is important to remember that key senior officials at any company can influence what financial information is disclosed to the public, and management's priority is often driven by how they can influence the bank's stock price.
The second type of transparency that would be very useful for the public stems from risk inputs into regulatory capital disclosures. The purpose of regulatory capital is for banks to survive unexpected losses. When the media writes about Tier I, liquidity and leverage ratios, how many analysts really know what the inputs are in the ratios? Even those familiar with some of the inputs are not in a position to create meaningful comparisons, since banks, for example, are not required to disclose the inputs into risk-weighted assets.
Basel III's much neglected Pillar III is the pillar that requires banks to provide disclosures about the quality of their capital and the type of credit, market and operational risk exposures they have. Unlike in Europe, to date, no U.S. bank is complying with Pillar III. Eventually, as banks comply with the liquidity standard and the leverage ratio, they will also have to give more detail about these two important buffers. Yet, given so much of this international capital framework relies on RWAs, banks should be required to explain how they come up with their major inputs, such as probability of default, loss severity, exposure at default and maturity of loans or debt instruments.
Lastly, the public would benefit from knowing how exactly a large bank would resolve itself in an orderly manner should it fail. Though this is type of transparency is rarely talked about, a major component of Dodd-Frank's Title I requires domestic banks and Foreign Bank Organizations to submit annual bank resolution plans, typically known as living wills to the FDIC and the Federal Reserve. Unfortunately, right now, the public only gets to see the living wills' executive summaries, which are of little value to anyone.
Thomas Hoenig, vice chairman of the FDIC, recently advocated making bank resolution plans public. Unfortunately, Hoenig's innovative proposal and great idea has barely been mentioned since he made this statement.
The living wills contain significant information, which would be very useful to the public in understanding bank's complex structures and products across myriads of global jurisdictions.
After seeing banks' thin living wills in 2012, the FDIC and the Fed released guidelines in 2013 requiring banks to describe not only challenges that could arise in a resolution, but also what steps they are taking to mitigate those challenges. Indeed, many challenges can arise in a bank resolution. For example, it could be that there is not just one insolvent bank, but multiple competing insolvencies.
Banks also have to disclose what type of global cooperation exists in the jurisdictions where they operate. For example, a failing bank is exposed to the risk that its actions could incentivize host supervisors or resolution authorities to ring-fence assets, which headquarters may need for liquidity purposes.
In their living wills, banks are also required to describe fully their operations and their interconnectedness. Services, for example, provided by an affiliate could be interrupted. Living wills also require banks to describe how their derivatives' and repos' counterparties might act in a period of stress when the bank is trying to resolve itself. Banks must also disclose to regulators how they are exposed to the risk of insufficient liquidity during a resolution at one or more key bank entities or in one or more jurisdictions.
Right now, the public has practically no information about a bank's counterparties and the exact nature of their contractual responsibilities. Without meaningful transparency on banks' financial reports, regulatory capital ratios and living wills, anyone writing about bank earnings is a willing actor in banks' quarterly earnings Kabuki theater.
Mayra Rodríguez Valladares is managing principal at MRV Associates, a New York-based capital markets and financial regulatory consulting and training firm. She is also a faculty member at Financial Markets World and the New York Institute of Finance.