News: Netting rules and balance sheets, US accounting Rules

12 March 2013 | Bill Hodgson

I came across this story which I need to read more, but it's an interesting analysis that US banks have a favourable accounting treatment which may attract change. http://www.bloomberg.com/news/2013-02-20/u-s-banks-bigger-than-gdp-as-accounting-rift-masks-risk.html I posted too soon, ISDA have already followed up on the story here: http://isda.mediacomment.org/2013/02/25/the-net-net-on-netting-and-risk/


There are two things being mixed together here. Derivatives assets and derivatives risk.On derivatives risk, derivatives assets (as are being discussed here) are not a very sophisticated or meaningful measure of risk - even when counterparty netting and collateralization are factored in - because they at best only reflect current exposure not potential future exposure (as the portfolio value moves over time in the future). Derivatives RWA should be a better measure and does include potential future exposure - especially post Basel III enhancements. Unfortunately conjectured inconsistent application of rules across banks and sheer complexity of the RWA models mean there are voices to continue using derivatives assets and also raw leverage (total assets over tier 1 equity) as well as RWA based ratios. For now, capital ratios are based only on RWA under Basel II/Basel III so the assets discussion has no bearing on bank capital.Derivatives assets then will stay with us and EU banks will continue to present footnotes in their statements to represent derivatives assets on netted US GAAP basis in addition to permit analyst comparison. While ISDA is right about legal netting, IFRS enforces an additional condition of daily net settlement of trades and collateral in one payment (and therefore a cleaner plug to pull on settlement when a counterparty goes down). This might make for less chasing post a counterparty default to recover funds which can be argued is more systemically robust. Also most investors would no longer need to hunt around footnotes to compare US banks with non-US banks.These benefits are worthwhile but what of the cost of implementing net settlement to be able to net down assets? The main cost is enabling settlement of trade cash flows and cash margin from the same bank account and re-route payment processing and accounting flows along with it (by agreement with each payment counterparty in turn). In an unchanging environment this would be a big / expensive project but since clearing and bilateral margin mandates are forcing banks to do re-work in the settlement space anyway, the incremental cost may not be as much as is being feared.

One follow up - on closer inspection the Bloomberg piece at the link mentions the existing Fed mandated 4% raw assets leverage ratio for US banks. IFRS derivatives netting adoption would put the the big 4 US banks close to the edge of this minimum. On the other hand there is scope to get back enough of the netting benefits lost through increased OTC clearing post-mandate and possibly introduction of bilateral net settlement for bank counterparties and some others. This explains why it is not so easy to for FASB to decide to adopt IFRS. Probably net net unless a 4% raw leverage ratio is added by EU bank regulators (as some have advocated) it feels like IFRS won't get adopted in the US.