Increased opacity for bank balance sheets?

The FASB last week voted, as expected, to allow financial institutions to use “significant” judgement in valuing their assets under FAS 157. While the increased guidance on other-than-temporary impairments has been welcomed by some, sceptics suggest that the move will result in even more opacity around bank balance sheets.

The changes permit companies to value non-active assets on a cashflow basis in certain circumstances, essentially allowing the assets to be valued the same as they would be sold for in an “orderly” sale, as opposed to a forced or distressed sale (see News Round-up for more). By some estimates, bank earnings are expected to rise by as much as 20% as a result. However, exactly how much the rules will be relaxed by remains unclear.

According to Espen Robak, president of Pluris Valuation Advisors, there were two major weaknesses in the FASB Staff Position (FSP) issued: the presumption that a sale is “distressed” in an “inactive market”; and that the given example was too vague. However, the FASB stated in a release announcing its decisions on 2 April that it had responded to participants in the comment process by removing the presumption of distress and improving the fair value example.

Nevertheless, Robak says: “The proposal was put together so quickly that the details appear to have been overlooked. More than 300 comment letters were filed with the FASB by investor groups whose feedback was negative, so it’s unclear who’s actually in favour of the changes.”

He adds: “The main concern for investors is whether the ultimate meaning of ‘fair value’ will be changed. If the FASB now changes the proposed FSP to make sure that the central measurement goal of fair value remains the same, then that’s a great relief for investors.”

Credit strategists at BNP Paribas nonetheless suggest that the new, more model-based approach means different banks could use different approaches in valuing similar securities. “We believe that such opacity is clearly not investor-friendly and will add to more investor scepticism once the dust has settled,” the strategists note. “This also relatively penalises those institutions that had either marked appropriately or not held toxic securities in the first place.”

However, Brian Weber, senior associate at Houlihan Smith & Co, points out that any time Level 3 assets are being dealt with, they will always be subject to professional opinion based on internal models. But, whereas previously financial institutions that hold these assets may have been pushed by their auditors towards using Level 2 inputs based off distressed sales in inactive markets, the new guidance means that banks no longer have to rely on such data.

Moreover, the previous guidance on other-than-temporary impairments versus temporary impairments was vague. According to Weber: “It is now possible to achieve a better indication of the extent of credit impairment by isolating, for example, the credit portion via looking at credit spreads or CDS levels. Before the new guidance was introduced, it was problematic to attribute a portion of the degradation in value to liquidity.”

Another criticism of FASB’s move is that it potentially reduces the effectiveness of the PPIP initiative. Weber reckons that a bank will be less likely to bring their poor assets to the PPIP because if the market values them at a lower level than the bank has marked them, it may be forced to take write-downs on the other assets on its book. “This will serve to reduce the liquidity that the PPIP would otherwise have brought to the table,” he notes.

Weber anticipates that the changes will ease the pressure on financial institutions in terms of having to make further write-downs in the future, but whether the Street buys into this remains to be seen. “Certainly banks will have more control over their own financial statements, which may be matched by increased investor scepticism.”

To increase transparency around the “illiquid” assets on bank balance sheets, Robak suggests that regulators could require banks to provide a list of all the positions on their balance sheet (like insurance companies do in their quarterly filings), which would enable investors to undertake their own valuations of a bank’s book. Alternatively, the big four accounting firms could require their clients to use models with market-based inputs in order to yield results in keeping with market realities.

“The proposed move changes the accounting rules for the whole economy, so are we throwing away good accounting to please a small segment of the economy?” he asks. “A better solution would be to make it easier for banks to deal with capital adequacy problems on the regulatory side.”