Monday, April 27, 2009

Dual US stance on valuing bank securities

Posted in the Financial Times by Krishna Guha and Aline van Duyn:

A decision by US bank regulators when conducting stress tests to take a hard line on the marking-tomarket of securities will force banks to hold more capital than would otherwise have been the case, officials acknowledge.

The decision in effect sets aside accounting guidance recently adopted by the Financial Accounting Standards Board, which gives banks greater latitude to depart from observed market prices when valuing securities held in "available-for-sale" portfolios.

The FASB made the change under pressure from Congress and from bankers who argued that the practice of marking securities to prices in illiquid and distressed markets was aggravating the financial crisis.

However, in a white paper issued on Friday, the Federal Reserve said supervisors disregarded the new FASB guidance when assessing how much capital banks needed to be confident they would comfortably survive a deep recession.

The Fed said regulators made this decision "in order to reflect greater uncertainty about realisable losses in stressful conditions".

The decision means the US authorities are now maintaining two approaches to valuing securities - a hardline approach when it comes to establishing how much capital banks need to hold pre-emptively against risks, but a softer approach when it comes to reporting losses relating to the same risks as they materialise.

This two-track approach could create an additional buffer between the amount of capital lined up now and the way banks report the erosion of that capital.

However, they believe shareholders will not be unfairly disadvantaged, as banks will be able to take the capital required to cover these potential losses in the form of government convertible preferred stock that converts into equity only as needed to cover losses.

There remains considerable ambiguity as to whether the conversion of such securities would be based on erosion of equity as assessed under the new accounting guidelines or under the hardline approach adopted for the purpose of the stress tests.

The difference in the valuation of illiquid securities under the hardline and softer approaches is also not clear.

The FASB guidance that was adopted was not as dramatic a scaling back of mark-to-market rules as had been called for by some politicians and bankers, meaning that the difference under the two approaches is not always significant.

The stress tests - part of a plan unveiled by Tim Geithner, Treasury secretary, to restore confidence in the financial system - were designed to ensure that the 19 leading banks in the US have enough capital in general, and equity in particular, to be able comfortably to survive a deeper downturn.

Analysts have wildly differing views as to the total amount of capital that the stress tests will identify as needed.

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