16 September 2018

Financial Times: Financial sector remains an impenetrable black box

[...]Fast forward a decade from Lehman’s collapse and reforms to regulation are supposed to have ironed out these wrinkles, bringing bank balance sheets and capital ratios more in line with reality. But the same dissonance between accounting and market measures persists — especially in the UK and the eurozone. Despite capital-bolstering measures, and the banks’ increasing reliance on “sticky” (insured) deposits rather than skittish wholesale funding, investors stubbornly refuse to believe that a book equity dollar is what it says on the tin.

Accounting is supposed to paint a picture that allows investors to assess the current valuation of a company. But in the topsy-turvy world of banks, it can conceal more than it reveals about economic reality. Balance sheet capital ratios may have risen, from 8 per cent before the crisis to 12 per cent now. But investors don’t believe them, especially the fiddly adjustments banks make that apply “risk weights” to asset values, thus cutting the equity required to fund positions.

Apply market values to banks’ unweighted total assets — the so-called leverage ratio — and you see a very different picture. This stands at a lower level than in 2006.

Investors’ doubts are not helped by some of the other games the banks play. One of the causes of the crisis was the opacity of their finances — not least the way they concealed positions off balance sheet. Rules were changed, purportedly to bring such deals on to a bank’s books. But a recent IMF working paper shows that the scale of off-balance sheet funding is actually higher now than at any time since the crisis, despite the overall shrinkage in bank balance sheets.

Then there are the games around profit, where the rules are structurally skewed towards the recording of upfront gains while delaying the recognition of losses.

There are also new risks which come from heightened central bank involvement in markets — lending against structurally overvalued balance sheets. Collateralised loans from the ECB now represent 6 per cent of Italian banks’ liabilities (the now defunct interbank market, whose collapse in 2007 acted as a genuine storm warning, only ever accounted for 1.5 per cent). This gives the central bank an incentive to play along with games that cover up hidden losses, and even insolvent institutions. The result is stagnation and the entrenchment of zombie banks.

For all the confident talk of strengthening, little has changed since 2012, when the investor Paul Singer warned there was “no major financial institution whose financial statements provide a meaningful clue” about its risks. Behind the confident façade presented by bank directors, auditors and regulators, the sector remains an impenetrable black box.

Full article on Financial Times (subscription required)

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