Bank Stress Tests: A Substitute For 'Mark-To-Market' Accounting?

by: John M. Mason
The FDIC Board yesterday issued a notice of proposed rulemaking that would require FDIC-insured state nonmember banks and state-chartered savings associations with more than $10 billion in total consolidated assets to conduct annual capital-adequacy stress tests. As of Sept. 30, 2011, the FDIC regulated 23 state nonmember banks with more than $10 billion in total assets. 

The Dodd-Frank Act-mandated proposal defines the term “stress test”; establishes methodologies for conducting stress tests that provide for three different sets of conditions, including baseline, adverse and severely adverse conditions; establishes the form and content of a stress-test regulatory report; and requires covered banks to publish a summary of stress-test results. 

The proposal is similar to one the Federal Reserve published in December.

(Daily Newsbyte release of the American Bankers Association, January 18, 2012)

The commercial banking industry has not wanted to adopt “mark-to-market” accounting. There are several reasons bankers do not want to do so, but, in my mind, the most prominent reason is that they don’t want to be accountable for taking on risk…both credit risk and interest rate risk.

Remember, I have been a banker for a large part of my professional life.

Generally, you hear bankers complain about mark-to-market accounting after-the-fact. That is, they complain when the value of their assets have declined. The decline in the value of an asset has either come because the asset has “gone bad” (for whatever reason), or, because interest rates have risen and the price of a security has declined.

In the first case, the argument forthcoming from the bankers is that either the asset needs time for the economy to recover or the asset needs time for the bank to help “work out” its problems. In the second case, bankers argue that they will hold the asset to maturity so that no capital loss will need to be realized on the asset.

Thus, the bankers have put on assets that have higher than average credit risk or long term assets that possess interest rate risk and have not had to account for any increase in the over all riskiness of bank assets until they either write off the asset or sell the asset for a price that is below its purchase price.

But, that can mean that there are a lot of “over-valued” assets on the books of the banks.

Because banks do not have to mark their assets to market, the banking system can have lots of “zombie” banks around, banks whose financial condition is unknown to their investors or depositors.

The presence of these banks, and not just the largest banks, can be noted in the Wall Street Journal article about Florida’s BankUnited. The BankUnited situation is unique in that it is a bank that was acquired by an individual, John Kanas, and a group of private-equity firms. BankUnited was a failing bank that was purchased from the FDIC and made into a profitable organization, one that is well capitalized and growing.

Yet, the desire was for the bank to grow more, and grow by acquisition, but this has not been possible because “other Florida banks are either too sick or too expensive…“Mr. Kanas’s team has examined more than 50 potential targets in the past few years but pulled the trigger on just one.”

The banking system is still not healthy and when “outsiders”, like Mr. Kanas and his team, actually get to review the assets of a bank during a due diligence, they find out just how fragile the banking system is.

The original acquisition of BankUnited was done in an assisted deal that “The FDIC estimates that the failure will ultimately cost its deposit-insurance fund $5.7 billion.” Deals are still being made for “failed” or “troubled” banks, (there are still about 850 banks on the FDIC’s list of problem banks) but the efforts to complete them and the frustration connected with “the regulatory red tape that is increasingly gripping the industry” are costly and tiresome.

Mr. Kanas is in the process of selling BankUnited and is leaving the industry. “’He is just tired,’ said a person who knows Mr. Kanas well.”

It seems to me that the imposition of “stress tests” on the banks with more than $10 billion in assets is a way to for the regulators to “mark-to-market” the assets of these banks! The regulators are to see what happens to the value of the assets of a bank under “three different sets of conditions, including baseline, adverse and severely adverse conditions.”

These “stress tests” are just simulations, but, the purpose of the tests are on to determine how vulnerable banks are to changing market conditions. In other words, are the banks sufficiently capitalized to withstand detrimental movements in financial markets.

This exercise basically “marks-to-market” the loans and securities held by a bank under different scenarios. And, the exercise is conducted by the bank regulators and not by the banks themselves. Furthermore, the Dodd-Frank mandate “requires covered banks to publish a summary of stress-test results.” That is, the results of these tests cannot be hidden.

Because the commercial banks would not reveal their risk exposure voluntarily and of their own making, the regulators will now design the tests relating to the risk exposure of the banks and will force the banks to reveal the results of the tests publically.

One just wonders how long it will take for the regulators to extend these “stress tests” to all financial institutions with assets of $1.0 billion or more. And, then...

I hope the bankers are happy with the consequences of their failure to disclose!