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The Bipolar World of Financial Institution Accounting


Why there's a world of difference between what regional banks and capital market banks are reporting.



Earlier this week, on CNBC, banking analyst Meredith Whitney said, "I think that the call this year, the trade this year has been short the regional banks and go long the capital markets banks." Can you tell me what was behind that?

-- Minyan John


As Whitney highlighted in her later comments, her call was based on the enormous amount of liquidity from the Federal Reserve raising asset market prices.

What she didn't detail, however, was why this would help the capital market banks, like Goldman Sachs (GS), Bank of America (BAC), and Citigroup (C), more than the regional banks, like Keycorp (KEY), Zions (ZION), and Regions (RF).

That answer is accounting.

If you look back into the dark days of the crisis, everyone and their brother was condemning mark-to-market accounting. And the reason was that the bulk of the assets on the balance sheets of the "capital market banks" are trading assets and investments subject to marked-to-market accounting. So when things were going down in price, the lower asset prices had to be immediately reported.

Since March, however, mark-to-market accounting has worked like a flywheel for the capital market banks. Not only have better marks (higher prices) brought enormous earnings to those banks' bottom lines, but because everyone was so focused on the financial condition of the banks, their turn propelled the whole market higher. And as the markets recovered, these same capital market banks then benefited from the underwriting fees associated with the huge surge in both equity and long-term debt issuance.

So from an earnings perspective it went from the worst of times to the best of times. (And as an aside it's why incentive compensation for the capital markets banks has "recovered" so quickly).

For the regional banks, it's been a very different story. Unlike the capital markets banks, the bulk of the assets on regional banks' books are loans. And loans use different accounting than investment securities. Generally speaking, banks don't increase the value of their loans in good times, and in bad times, banks estimate what losses they see ahead and take reserves accordingly.

With consumer and commercial credit quality continuing to deteriorate over 2009, the regional banks have continued to take larger and larger reserves, even while the markets have gone higher.

But now the question is what happens from here.

If you believe that markets will go higher from here, then the capital market banks should continue to benefit.

Similarly if you believe that the economy is going to improve from here, then the regional banks should also benefit. And here I would note that the regional banks are more likely to benefit from an improving economy because of their sizable existing reserves -- and their ability to record any reduction as earnings.

But I think it's also worth considering the downside case. Unless the capital market banks have significantly reduced their risk profile, a downturn in the market is likely to affect those banks more severely than the regional banks (at least in the short run). But if the downturn in the markets is a function of rising unemployment, then I suspect that regional bank earnings will come under further pressure as well.

In any case, though, I think it worth remembering that accounting doesn't change the outcome, just the timing at which it becomes apparent. With mark-to-market accounting, changes (for better or worse) appear faster than with accrual accounting. (But I would also offer here that both continue to rely heavily on management judgment, as for many securities market prices can be highly subjective.)

Now having said all this, I would draw your attention to an op-ed in this morning's Wall Street Journal. Currently there's a big debate going on among Congress, banking regulators, and the accounting industry regarding the basic rules for reporting financial asset values.

The accounting industry would like all financial assets -- loans and securities -- to be reported using fair value accounting (to make it easy, think mark-to-market). The banking regulators and Congress are concerned that this will add risk to the financial system -- inasmuch as investors will then know (at least quarterly) what bank loan assets are worth, based on then-current market values. So, as a result, Congress wants the ability to "suspend" mark-to-market accounting in the event of a future crisis.

As this is clearly a work in process, I would recommend that Minyans stay tuned.

-- Peter
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