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The commercial banking system in the United States does not seem to be "out-of-the-woods" yet, in spite of the fact that 15 out of the 19 largest banks in the country recently passed the stress test administered by the Federal Reserve.

For one, many executives of the commercial banks involved don't seem to understand how the Fed got many of its results. In conference calls held after the results of the stress tests were released the banks raised major questions over how calculations of capital were made.

Healthy institutions want to understand why there were some large gaps between their own capital estimates and the Fed's, according to people close to those banks. Some of the five lenders that didn't pass the test say questions about the Fed's scoring complicate reapplying for approval to raise dividends or buy back stock…

Problems in interpretation were bound to occur, but, to my mind, the commercial banks have created their own nightmare.

The real problem: mark-to-market accounting, or, the lack of it.

Executives in commercial banks don't like mark-to-market accounting. The basic reason is that they don't like to admit that they have made mistakes or that they have taken on too much risk or that they just don't want to deal with messy issues.

When the value of bank assets decline, either because loans have gone sour or because interest rates have risen and the market value of securities have dropped, analysts argue that the banks should mark their assets to market so that they can get a real picture of how the bank is performing…whether or not the bank is solvent.

Bankers argue back that they shouldn't be made to mark their assets to market "after-the-fact" because that forces them to change their balance sheets that were not expected of them before. And, they also plan to hold their securities to maturity, when they would get their full value repaid, and they also need time to "work-out" their troubled loans as the economy improves. They argue that analysts, by asking for them to go to mark to market accounting, are changing the "rules of the game" after the economic and financial environment has changed.

So, the bankers can put on riskier loans, buy securitized bonds, mismatch maturities, place SIVs off-balance-sheet, and so forth, and when the economy turns south, they do not have to reveal to the public…and the regulators…what their decisions have done to the health of the bank!

They ask, "I have mismatched maturities to earn a few more basis points on my return of assets to try and keep up with the competitors, and now, since interest rates have gone up I have to mark the longer term assets to market?"

Well, you took the risk, you must own up to the consequences. Arguing that you intend to hold the assets to maturity doesn't "hold water" because as short-term interest rates continue to increase you will either have to sell your assets or work with a negative interest rate spread.

Also, Mr. Banker, when you made riskier loans…like subprime loans…you were stretching for yield. You made the choice. As the market moves, so does the value of your assets. Own it.

Since the commercial banks have fought the development of an adequate mark-to-market accounting process, the Federal Reserve…and others…have tried to create a substitute for this accounting treatment of assets. This substitute is called the "stress test."

The "stress test" works with assumptions. "Last November (the Fed) published test assumptions, such as a 13% unemployment rate in a U. S. recession.

But the Fed is resisting full disclosure of its methodology, hoping to retain the flexibility to make future changes and prevent the banks from gaming the numbers…"

The commercial banks "game" their own accounting numbers by not marking their assets to market. The fear with stress tests is that the commercial banks will "game" the tests if they know what the Fed's assumptions are. The commercial banks want it both (all) ways.

And, how well off are the commercial banks?

Jesse Eisinger writes in the New York Times about the annual report of the Federal Reserve Bank of Dallas. Although the article concentrates on the issue of "too big to fail", Eisinger does print a quote from an essay in the annual report written by Harvey Rosenblum, the head of the research department at the Dallas Fed.

Rosenblum wrote:

Monetary policy cannot be effective when a major portion of the banking system is undercapitalized. Many of the biggest banks have sputtered, their balance sheets still clogged with toxic assets accumulated in the boom years.

This from the head of a research department within the Federal Reserve System!

And, what about the other banks in the system?

As last reported by the FDIC there were 814 commercial banks on the list of problem banks. There are many more on the edge of becoming problem banks. The number of commercial banks in the United States dropped by 240 last year and only 92 of these were bank closures. In both cases, the numbers included no banks that could be called "the biggest banks."

You wonder why the Federal Reserve has pumped almost $1.6 trillion in excess reserves into the banking system?

I have argued for more than two years now that the Fed's ease is not just about getting the economy going again. In my opinion the Fed has been as generous as it has been in order to allow the FDIC to close or to approve the acquisitions of troubled banks in an orderly manor so as to allow the banking system to adjust to its "insolvency" problems as smoothly as possible.

I agree with Mr. Rosenblum, I think that there are still too many "toxic assets" on the balance sheets of commercial banks…large, medium-sized, and small.

Without some kind of adequate mark-to-market accounting process in the commercial banking system, we will continue to be "in the dark" with respect to the health of banking institutions and banks will be able to continue to "game" us.

Having an adequate mark-to-market system in place will cause bank managements to conduct their businesses in a less risky fashion. And, only by having an adequate mark-to-market system in place will bank managements move to address the problems they face in real time, something they currently are loathe to do.

Source: Commercial Banks: How Safe Is The Banking System?