(Updated to change Esther Mills’ quote in the fifth paragraph.)
Warning: Banks in the U.S. may be bigger than they look. That label might be required for the country’s four largest lenders if Thomas Hoenig, vice chairman of the Federal Deposit Insurance Corp., has his way. The issue is what banks include on their balance sheets, where they list assets, such as loans and investments, and liabilities, including deposits. U.S. accounting rules allow banks to keep most mortgage-linked bonds off the books and record a smaller portion of their derivatives than European peers, underestimating the risks firms face and lowering how much capital they need. “Derivatives, like loans, carry risk,” Hoenig says. “To recognize those bets on the balance sheet would give a better picture of the risk exposures that are there.”
Including more mortgage bonds that are packaged into securities and applying international standards for derivatives would make some U.S. banks look twice as big as they say they are, according to data compiled by Bloomberg. JPMorgan’s (JPM) balance sheet would swell to $4.5 trillion from $2.3 trillion. Bank of America (BAC) and Wells Fargo (WFC) would double their assets, while Citigroup’s (C) would jump 60 percent. Their combined assets would be $14.7 trillion, based on third-quarter 2012 figures, the latest available—equal to 93 percent of last year’s gross domestic product.
Derivatives are financial contracts in which two parties agree to swap cash or securities at the end of a predetermined period based on the change in value of stocks, bonds, currencies, or other instruments. U.S. rules allow banks to “net” their derivatives—they can add up all the contracts with their trading partners and show only what would be owed if all the contracts were settled at the same time. That approach assumes the trading partners will be able to pay—which might not be true in a crisis. The government had to rescue American International Group (AIG) when it couldn’t pay banks on derivatives tied to mortgage bonds. Also, when a bank’s solvency is in doubt, trading partners can demand to be paid immediately, causing a run, according to Anat Admati, a finance professor at Stanford University.
Mortgage securities present similar concerns. Banks don’t have to carry on their books mortgage securities backed by government-owned Fannie Mae (FNMA) and Freddie Mac (FMCC). The reasoning is that the government guarantee makes them safe. Still, those bonds are not risk-free. Since 2008, JPMorgan, Wells Fargo, Bank of America, and Citigroup have faced demands to take back $67 billion of mortgages packaged into securities because the loans hadn’t met Fannie and Freddie’s underwriting standards.
Lenders say they have improved procedures for loans they make and transfer to Fannie Mae and Freddie Mac for packaging into mortgage bonds, eliminating the need to put them on the balance sheet. Esther Mills, president of Accounting Policy Plus, a consulting firm, doesn’t share that view. “There was clearly a failure by certain institutions to appropriately assess the liabilities before the crisis,” she says. “Are there enough liabilities going forward for the billions of mortgages being transferred?”
The U.S. Financial Accounting Standards Board and the International Accounting Standards Board pledged a decade ago to converge the two bookkeeping systems. After six years of meetings, they remain divided. In 2011 the U.S. board came close to moving in Europe’s direction on derivatives. There was pushback from the largest U.S. banks, which said the gross values of their derivatives overstate their actual positions, says a person familiar with the talks, and the board dropped the plan.
In a January survey of 70 banks worldwide conducted by auditing firm Deloitte, 88 percent of respondents said they don’t expect a convergence on the accounting rules most relevant to lenders, including derivatives, balance-sheet consolidation, and how to reserve for loan losses. Leslie Seidman, chairman of the U.S. board, and Hans Hoogervorst, head of the international panel, both said at a January conference in New York that they hadn’t given up. “I still hope for one standard,” Hoogervorst said. “But at times it’s easy to be discouraged.”
Meanwhile, U.S. banks will continue to follow current standards, potentially hiding risks. “There are probably some dangerous things left off the balance sheet still, and we’ll only find out what in the next crisis,” says David Sherman, an accounting professor at Northeastern University in Boston. “But how many times do we have to go through this to figure it all out?”