Why Believe Bank Earnings Yet?

Well, it’s earnings season again. One has to wonder, however, why anyone would believe the numbers being touted out quarter after quarter in the ongoing financial crisis. Already, there has been ample evidence of accounting forbearance, with explicit cooperation by FASB, the SEC, and the bank regulators. I argue that while such forbearance may be important for stabilizing bank conditions – albeit at a low level – it is dragging out the recovery for longer than otherwise need be the case.

It is common for regulators to augment bailouts with accounting forbearance. In the Great Depression, as today, accounting forbearance was an important part of recovery policy. Throughout the Depression there persisted conflict between the Comptroller of the Currency (and later the FDIC) and the Federal Reserve over accounting forbearance. The OCC and FDIC desired strict financial cutoffs in order to protect bank creditors, particularly depositors. The Federal Reserve, however, wanted to smooth market effects on bank values, reducing the impact of the Depression upon banks in a more subjective manner.

To some extent, the strategy was born of necessity because nobody really knows asset values in times of high asymmetric information financial crises. As a result, although successful bailout programs of the Great Depression restricted credit or other assistance to reasonably sound institutions the seemingly simple strategy was, in reality, frightfully complex. Nonetheless, the RFC was explicit about the fact that it often evaluated firm solvency and soundness on the basis of future market expectations or favorable environmental conditions that were (and still are) difficult or impossible to quantify.

The same happened in the recession and bank crisis of 1990-1992, when supervisors again practiced widespread accounting forbearance. More recently, Huizinga and Laeven (“Accounting Discretion and the Reliability of Banks’ Financial Accounts,” IMF Working Paper, June 18, 2009) suggest that banks today are overvaluing assets on a strictly accounting basis, most plausibly with the tacit collusion of their regulators.

Laeven and Huizinga review how “pressures arose during the summer of 2008 to provide banks with more leniency to determine the fair value of illiquid assets such as thinly traded MBS to prevent these fair values from reflecting ‘fire-sale’ prices. Correspondingly, on October 10, 2008 the Financial Accounting Standards Board (FSAB) clarified the allowable use of non-market information for determining the fair value of a financial instrument when the market for that instrument is not active. Subsequently, on April 9, 2009, the FSAB announced a related decision to provide banks greater discretion in the use of non-market rather than market information in determining the fair-value of hard-to-value assets.” (p. 4) But while Laeven and Huizinga suggest the rise in stock prices resulting from such changes was due to banks “enhanced ability to maintain accounting solvency,” I would suggest it was merely because of the advantages of reduced writedowns.

As the public is learning, “banks have considerable discretion in the timing of their loan loss provisioning for bad loans and in the realization of loan losses in the form of charge-offs. Thus, banks that are pressured by large exposures to MBS and related losses can attempt to compensate by reducing the provisioning for bad debt. Indeed, [Laeven and Huizinga] find that banks with large portfolios of MBS report relatively low rates of loan loss provisioning and loan charge-offs.” (p. 5) Moreover, Laevena and Huizinga remind us that banks can “…augment the book value of assets by reclassifying MBS available-for-sale as held-to-maturity. Indeed, [they] show that the share of non-guaranteed MBS that are held-to-maturity increased substantially in 2008. Reclassification of this kind is also advantageous for banks whose share price is depressed on account of large real estate related exposures. Consistent with this, [they] find that the share of MBS kept as held-to-maturity is significantly related to both real estate loan and MBS exposures. Moreover, these relationships are stronger for low-valuation banks.” (pp. 5-6)

Successful Great Depression programs often took a measure of control over institutions to assuage junior creditors and nurse firms to profitability and recovery over the long run, both helping to ensure the success of the programs and stemming moral hazard. We have done neither in the current crisis. Without confidence in either bank accounting or management, the recovery can be expected to take a long time.

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