The Basel Committee says that regulatory capitalis set for public purposes, and it implies some degree of standardization. By contrast, as we saw in sections 2 and 3, economic capital is tailored to the bank’s own risk appetite, and it represents pri- vate costs of failure. As Figure 14.2 suggests, the dividing line between financial accounting and management accounting follows, more or less, the same dichotomy.
The budget and economic capital, which find themselves on the right side of Figure 14.2, are neither standardized nor regulated. Both address the future whether this is:
● Future cost, the business of the budget
● Future risk, the mission of economic capital.
Risk, of course, can be monetized, and taking care of private cost of failure through precommitment is a matter of respectability for the credit institution. To make such precommitment a realistic proposition, well-managed banks ensure that economic capital methods assess the amount of money needed to support:
● Well-defined business activities, and
● Exposures that inevitably are associated to them.
Based on such assessments, economic capital can be redefined as the amount necessary to cover losses up to a specified probability: for example, within a 1- year timeframe, in 999 out of 1000 possible scenarios,6 which means at the 99.9% level of confidence (α⫽ 0.001).
The role of respectability capital becomes evident after having defined the level of confidence in an acceptable way, for instance at the level of 999 out of 1000 cases – while VAR only covers 99 out of 100. This creates a buffer of liquidity which becomes necessary to face the twists of the market. Theoretically, at least, this should provide a good frame of reference as far as market discipline is concerned.
The downside is that there exist internal contradictions to market discipline because investors and analysts are classically concerned about earnings per share – and banks are fully aware of it. Reading the fine print of FDIC’s Quarterly Banking Profile, for the third quarter of 2004 one sees that while the level of
• BALANCE SHEET
• P&L STATEMENT
•BUDGET
•VIRTUAL B/S
•ECONOMIC CAPITAL FINANCIAL ACCOUNTING
IFRS, US GAAP
MANAGEMENT ACCOUNTING MANAGEMENT'S OWN PLANS
AND METHODS
STRUCTURED ENVIRONMENT
UNSTRUCTURED ENVIRONMENT
REGULATORY CAPITAL UNDER BASEL II
Figure 14.2 Accounting standards setters and regulators promote a structured environment of management reports
unpayable debt grows, US banks have been drawing down rather than beefing up their level of loan loss reserves.
● Six times in seven quarters (Q4 2002 to Q2 2004), the amount of money the banks set aside as provision for loan losses has declined, and
● The $7.3 billion the banks set aside in the third quarter of 2004 was the small- est since the third quarter of 2000, when the loan portfolio was 23% smaller.
A policy of drawing down loan reserves when credit risk increases is evidently counterproductive, and contradicts everything that has been stated about respectability capital. This situation seems to be more critical for banks with $10 billion or more in assets, the big banks, where according to FDIC net charge-offs exceeded provisions for the seventh quarter in a row. Moreover, the overall level of loan loss reserves declined for the fourth time in five quarters.
It is self-evident that when net charge-offs exceed provisions, credit institutions are not adding enough in reserves to cover the loans they are writing off. Indeed, in the third quarter of 2004, the big banks provisions covered only 93% of their write-offs.7So much for observance of regulatory capital rules.
An article in Business Weekhas pursued this frame of reference, pointing out that in 2004 banks had an easy way to juice their profits by allocating a little less money to loan loss reserves. Together, the FDIC and Business Weekreferences suggest that creative accounting is alive and kicking, because all companies dread profit shortfalls. If nothing else, missing analysts’ estimates damages their credibility on Wall Street.
Banks jumped ahead of themselves to trim loans reserves, and therefore regula- tory capital, because in 2003 the economy had improved and defaults slowed.
With that hindsight, in 2004 many credit institutions decided they did not need as much in reserve as they did in 2003. This was an easy way to increase their earnings per share. ‘A lot of banks may do this from time to time to meet esti- mates,’ said Brian Shullaw, senior research analyst at SNL Financial.8
This is, however, a policy full of risks because the economy is not static. As credit institutions write more loans, they have to replenish reserves put aside to cover the likelihood of loan losses. Credit conditions are never stable. When eco- nomic growth slows and interest rates rise
● Credit conditions worsen, and
● Banks need to set aside even more money than would otherwise be necessary.
Indeed, the 2004 dwindling in loan reserves documents that it was unwise to abandon the expected losses (EL) formula of Basel II. This took place mid-October 2003 at the Madrid meeting of the Basel Committee on Banking Supervision, on the hypothesis that banks anyway account for expected losses. What followed in 2004 documented that the hypothesis on which that decision was based was too optimistic. Without an iron-clad algorithm given by regulators which establishes a level-playing field. Credit institutions can play games with loan loss reserves:
● This distorts the true quality of bank earning, and
● It also damages business confidence, as the news of dwindling loans reserves becomes public.
The same Business Weekarticle to which reference was made, uses as an exam- ple Detroit’s Comerica, which had one of the largest drops in its loan loss reserves relative to total assets. Not only did Comerica fail to add money in the fourth quarter of 2003, but it also extracted $21 million from its credit risk reserves.
● That gave it an extra $98 million in income, or 57 cents a share, and
● It allowed the bank’s management to beat analysts’ earnings estimates by 10 cents.
But is this the reason why a credit institution keeps reserves for loan losses?
Another reference by Business Week concerns Citigroup, which gained a few extra cents in its income statement from replenishing reserves by a smaller amount than before. This was enough to beat analysts’ earnings estimates by 1 cent. In a January 2005 conference call, Citi Chief Financial Officer Sallie L.
Krawcheck said that the reserving process was done in mid-quarter based on a mathematical formula. Krawcheck added that: ‘We, as a company, work very hard to systemize the process around rigorous analytics,’ but then she warned analysts not to expect substantial reductions in provisions in the future.
Eventually, Pillar 3 market discipline might make this practice a relic, because while investors and financial analysts appreciate that victories require taking risk, they also know that reductions in capital adequacy mean greater financial riskin the case of adverse change in market conditions. Low reserves are akin to mispricingof loans in connection to credit risk.
Mispricing is often done voluntarily, related to commercial risk. An example is volatility smile, the guesstimate that future volatility would be benign, which per- mits the entity to sell cheap options. Sometimes options are purposely mispriced
in order to sell them like hotcakes, while forgetting that the synergy of commer- cial exposure and financial risk can create an earthquake.