IGNORANCE ISN´T BLISS FOR BANKS / THE WALL STREET JOURNAL

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Updated November 12, 2012, 4:37 p.m. ET

Ignorance Isn't Bliss for Banks

By DAVID REILLY

 

 

 

The only thing worse than a big loss at a bank is pretending it doesn't exist.

Many financial firms discovered this the hard way during the financial crisis. By ignoring losses, they dug themselves into ever-deeper holes.




Despite that, many banks now want regulators to allow them to again bury their heads in the financial sand. This week, the Senate Banking Committee plans to hold a hearing on new capital rules, with an expected focus on worries that they will harm community banks. Bank regulators last week said they would hold off on finalizing the rules, known as Basel III, until sometime next year.




Small banks, in particular, have expressed concern. The Independent Community Bankers of America, a trade association, already has called on regulators to exempt banks with less than $50 billion in assets from the new rules or, failing that, some parts of them.




Among these: a requirement that banks include in their calculations of capital unrealized gains and losses on securities they hold. The argument is that including these will subject capital ratios to unnecessary volatility. This is because the banks say they intend to hold the securities in most cases to maturity, so the losses won't actually hit them.



But as many banks learned during the financial crisis, market storms have a way of swamping intentions. A bank facing a funding crunch may be forced to sell holdings, and recognize losses, even if it didn't originally plan to do so.



Since banks borrow funds on a short-term basis to lend them out for longer periods, it is imperative for investors and regulators to have a current view of what such assets are worth. That is especially the case with securities, because these tend to have ready market values, unlike the loans banks hold on their balance sheets.



Current rules don't require gains and losses on such holdings to be included in capital, although they affect a bank's book value. The crisis showed the flaw in this as investors lost faith in capital ratios partly because they excluded such losses.



Also, banks have long argued that their loan books shouldn't be marked to market prices because loss reserves are created against these holdings. That isn't the case with investment securities, making it even more dubious to try to ignore even short-term, unrealized losses.



The issue of how to treat these gains and losses is of particular importance today. With banks awash with deposits and loan growth still tepid, their holdings of securities have been rising.




Available-for-sale securities at all banks totaled about $2.6 trillion at the end of the second quarter, or about 19% of total assets, according to the Federal Deposit Insurance Corp. That compares with 14% for the same period in 2008.



Superlow interest rates make this even more of an issue, as when rates eventually rise some banks could be caught holding low-yielding securities that show losses. This will especially be the case if some banks are today investing in ever-longer-dated securities to counter pressure on their net-interest margins.



Knowing that this could have capital consequences is one way to instill market discipline. Aside from that, capital ratios need to reflect the risks banks have taken. Otherwise investors will find new reason to doubt their usefulness or the case for buying bank stocks.

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