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This is a preprint version of the author's article, "Market Value Accounting and the Bank Balance Sheet," Contemporary Policy
Issues, April 1990, v. 8, iss. 2, pp. 82-94.
Working Paper 89-4
THE FEASIBILITY OF MARKET VALUE ACCOUNTING
FOR COMMERCIAL BANKS
David L. Mengle
Federal Reserve Bank of Richmond
October 1989
The author thanks George Benston, Robert Graboyes, and Edward Kane for
helpful comments, and Robert LaRoche for research assistance. The views
expressed are those of the author and not necessarily those of the
Federal Reserve Bank of Richmond or of the Board of Governors of the
Federal Reserve System.
As the severity of the problems facing the federal deposit insurance
funds becomes more obvious, the chorus of support for some form of market
value accounting is growing.
Proponents cite the benefits of increased
disclosure and the discipline such accounting would bring about.
Opponents
argue that market value accounting is infeasible because it would be too
costly and too inaccurate to be worth the effort.
While the cases for and against market value accounting have been made,
relatively little has been written on how it could actually be applied in
practice.' The objective here is to focus on the feasibility of market value
accounting for depository institutions and on where the difficulties lie.
that end, the paper will concentrate on three areas:
To
First, why should
depository institutions adopt market value accounting? Second, what are the
practical obstacles to instituting market value accounting and what is the
practical significance of such difficulties? Third, how could the most severe
obstacles be overcome?
While the practical problems of implementing market value accounting
have received little attention in the academic literature, practitioners in
the private sector are developing knowledge that could be used either directly
or indirectly to mark bank portfolios to market.
This paper will attempt to
inventory the knowledge amassed thus far.
'For exceptions, see Johnson and Peterson (1984) and Benston (1989).
2
What is Market Value Accounting?
At present, banks report the value of assets and liabilities at
historical cost values, also known as book values.
This is required under
both Generally Accepted Accounting Principles (GAAP).
In contrast, market
value accounting would require that assets and liabilities be reported at
current values, that is, reported as the discounted value of expected cash
flows or, if traded in active markets, at the values they would realize if
sold today.
Market value accounting need not completely displace book value
accounting. For example, market value accounting could be required only for
limited purposes, such as determining capital adequacy and solvency.
It is
even possible that depository institutions and their regulators could keep
market values confidential and allow book value accounting for all other
purposes. While reporting separate sets of data might seem costly to some, it
is already the practice in many firms to submit separate reports for financial
reporting purposes, another for tax purposes, and yet another for regulatory
purposes.
Still, market value accounting admittedly would require a far more
complex set of reporting requirements than has heretofore been the case.
An example of a market value accounting proposal may be found in Johnson
and Peterson (1984).
The authors proposed that values of assets and
liabilities be reported at book values as is now done, but supplemented by
contra accounts for each category of balance sheet item.
The accounts would
serve as "current value reserves," which reflect the difference between
historical costs and market values in a manner somewhat analogous to loan loss
reserves.
The result would be equity measurements that more closely reflect
3
market values, but book values would still be reported and accessible to those
wishing to use them.
In contrast to market value accounting, book value accounting uses the
ultimate collectibility of an asset as its criterion for value.
This was most
obviously stated by federal regulators in 1938 in a joint declaration. Up to
that time, bank investment securities had been reported at market values while
loans and other bank assets were reported at book values.
The declaration explicitly accepted ultimate collectibility for
securities. For example, the Board of Governors wrote that the declaration
"...recognizes the principle that bank investments should be considered
in the light of inherent soundness rather than on a basis of day to day
market fluctuations. It is based on the view that the soundness of the
banking system depends in the last analysis upon the soundness of a
country's business and industrial enterprises, and should not be
measured by the precarious yardstick of current market quotations which
often reflect speculative and not true appraisals of intrinsic worth."
[emphasis added.]2
Further, the Federal Deposit Insurance Corporation argued that valuing
securities at market encouraged speculative trading, "placed primary emphasis
on the trading aspects rather than the investment aspects" of securities, and
distorted computations of capital by allowing net worth to be influenced by
the "state of the bond market."3
Somewhat less obvious was the significance of deleting "slow" loans as a
category.4
Up to that time, loans could be classified as "estimated loss," in
which some or all of a loan could not be collected; "doubtful," in which some
loss was expected; and "slow," which apparently referred at one time to loans
2
Board of Governors (1938), p. 564.
3
Federal Deposit Insurance Corporation (1938), p. 65, 74.
4
Hempel et al. (1989), p. 11.
4
that would eventually be collected but were not "collectible at the stated
maturity. n5
The declaration made it clear that such loans would no longer be
criticized by examiners if they were expected to be paid.
More to the point
was a passage by the Board of Governors:
"...the principle is clearly recognized that in making loans, whether
for working capital or fixed capital purposes, the banks should be
encouraged to place the emphasis upon intrinsic value rather than upon
liquidity or quick maturity."6
By denying that a slow loan was less valuable and therefore worthy of
reserving, the regulators confined the valuation criterion to ultimate
collectibility. Indeed, the significance was probably not great at the time
because it is likely that banks tended to engage in mostly short-term lending.
In addition, slow loans probably did not suffer much present value impairment
because of the generally low interest rates prevailing at the time.
If market value accounting were instituted, the criterion for value
would more closely resemble the economist's concept of opportunity cost.
Market value accounting would emphasize net present values of assets and
liabilities rather than ultimate collectibility. Further, it would recognize
the time value of money, and would essentially reverse the 1938 principle that
loans that are behind should be valued the same as those paying on schedule.
As one opponent of market value accounting has admitted, banks have in
some respects implicitly accepted the principle of market valuation.7
example, in 1987 John Reed of Citicorp ordered that his bank set aside
5
FDIC (1939), p. 62.
6
Board of Governors (1938), pp. 563-64.
7
Cates (1988).
For
5
significantly larger loan loss reserves for Third World debt than had
previously been industry practice. As such he recognized that the loans were
not worth what the books said they were worth.
And since that time, many
regional banks have sold most or all of their Third World loan portfolios.
Since the transactions largely took place in an active secondary market, such
sales in effect marked a portion of the banks' loan portfolios to market.
Market value accounting has also drawn interest from two regulatory
bodies. The Financial Accounting Standards Board (FASB) published an
"exposure draft" in 1987 of a proposal that market values of financial
instruments be reported.
Specifically, the proposal suggested that
institutions be held to the following disclosure standards:
The market value of each class of financial asset and liability shall be
disclosed, either in the body of the financial statements or in the
accompanying notes, unless the entity is unable to determine or estimate
that value.
Quoted market prices, if available, shall be used to determine market
value. If quoted market prices are not available, an estimate of the
market price of the financial asset or liability shall be used. If
estimates of market price are used, a description of the method(s) and
significant assumptions used to estimate the market value shall be
disclosed.
If the market value of a particular financial instrument (or group of
financial instruments within a class) cannot be determined or estimated,
the following shall be disclosed:
a.
Reasons the market value could not be determined or estimated.
b.
Information about the carrying amount, interest rate, maturity,
and other characteristics pertinent to the value of the financial
instrument or group of instruments."8
At present, the FASB proposal is still open, but consideration of market
valuation has been delayed in favor of a two-phase approach.
During the first
phase, FASB and a task force made up of representatives from private financial
8Financial
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phase, FASB and a task force made up of representatives from private financial
firms and regulatory agencies will concentrate on disclosure standards for
off-balance sheet activities. This phase is now underway.
In the second
phase, the task force will return to the more general question of disclosure
of market values of financial instruments.
In addition to FASB, the now-defunct Federal Home Loan Bank Board showed
some interest in market value accounting.9
In the early 1980s, a task force
was set up to study the feasibility of market value accounting.10 But the
only change to come of it was to require the (confidential) reporting of
thrifts' maturity and rate structures of their assets and liabilities (just as
banks were already required to report in Schedule RC-J of the Call Report).
Interestingly, while the thrift regulators moved somewhat in the direction of
increased disclosure of information relevant to determining market values,
bank regulators have reduced somewhat their requirements for reporting the
same information.
Shortly before it ceased to exist, the Bank Board also took up the
problem of marking securities portfolios to market.1 "
Its successor
organization, the Office of Thrift Supervision (OTS), delayed until January 1,
1990, the imposition of a rule requiring that securities in investment
accounts be marked to market unless an institution can show "intent and
ability to hold to maturity under any foreseeable circumstances."
9
See, for example, White (1988).
0
Federal Home Loan Bank Board (1983).
1 Federal Register, vol. 54, June 1, 1989, pp. 23457-23471; see also
"
"It's Time to Substantiate Securities Trades," Federal Home Loan Bank Board
Journal, August 1989, pp. 16-19.
7
While one might interpret the rule as a move toward market value
accounting, the Bank Board's justification was based on their interpretation
of GAAP.
That is, the Bank Board believed that it was not the intent of GAAP
that book value accounting of securities should be used as a means of
concealing losses until gains could be realized from a sale.
Further, it is
probable that when and if the rule is finally issued it will apply to all
depository institutions.
2
Why Market Value Accounting?"
The general argument in favor of market value accounting is based on the
relevance of economic values to decisions. That is, the actual opportunity
costs of a decision include both explicit and implicit costs.
Since
accounting costs are largely explicit costs, basing decisions on them does not
necessarily use all relevant information.
Put differently, economic costs and
values are meant to be a fuller representation of reality than are accounting
costs and values.
Still, as pointed out by Benston (1982,1989), that does not
mean the accounting numbers have no value.
Rather, it means that market value
accounting and book value accounting have different objectives.
The most important argument in favor of market value accounting is that
it would establish an economically meaningful standard for determining
solvency.
In other words, it would attempt to use actual values to determine
solvency rather than rely on values from some time in the past.
And if
regulators close a bank when its market value goes negative rather than
12 Edward Kane and George Benston have been the leading spokesmen for
market value accounting. See Kane (1985), Benston et al. (1986), and Benston
(1989).
8
waiting for book value to go negative, losses to the deposit insurance funds
should be lower.
Second, capital regulation would be more meaningful if net worth were
measured with actual economic values of assets and liabilities. Measurement
of capital ratios under market value accounting would account for interest
rate risk and imbalances between asset and liability durations.
This would be
particularly important in the case of thrift institutions making long-term
mortgage loans.
In contrast, under the current risk-based capital system for
banks there is no explicit recognition of interest rate risk.1 3
Further, to
the extent that market value accounting will be able to capture some of the
"going concern" value of banks, capital ratios should be a better
approximation of economic net worth.
Finally, marking assets to market would reduce some perverse incentives
under the existing system to sell high quality assets to realize gains while
retaining poor quality assets to avoid recognizing losses.
For example, a
bank wishing to build up its capital might be tempted to sell a profitable
subsidiary in order to realize the gain while at the same time leaving
troubled loans on its books rather than sell them at a loss.
Under market
value accounting, in contrast, the gain in value of the profitable subsidiary
and loss on the loan should already be recognized so the bank would have less
incentive to sell the good asset.
Federal Home Loan Bank Board's proposed risk-based capital
requirements include a specific component that recognizes interest rate risk.
Federal Register, vol. 53, December 23, 1988, pp. 51800-51820. Financial
Accounting Standards Board (1987) also recognizes that market values help to
determine if an institution manages its "assets and liabilities in a
coordinated way" (p. 70).
13The
9
It is difficult to overemphasize the importance of such incentives.
If
the market value of an asset is below its book value, a bank has little
incentive to immediately recognize the loss by selling the asset.
But it
might be in the bank's economic interest to do so since the proceeds of the
sale could be reinvested. And if an asset's market value is above its book
value, the only way the increased value can be immediately recognized is by
selling (or by selling and leasing back).
Such a sale would be especially
unfortunate if there is added value from "synergies" with the bank that would
not be captured by the purchaser. Put more precisely, there may be certain
transaction costs involved in an activity carried on by a bank that are
reduced through the collection of valuable but private information that would
not be transferred if the asset were sold.
So far, the arguments advanced for market value accounting would not
necessarily call for complete public reporting of market values.
The main
argument for full use of market values is based on the benefits of increased
disclosure. Depository institutions would be subject to increased discipline
to avoid excessively risky behavior. Regulation, too, would benefit since
regulators' actions could be evaluated against the market's estimates of an
institution's condition.1 4
But it is also possible that the additional costs
involved in full use of market value accounting may not be justified by the
benefits to users such as stockholders, managers, and accountants, none of
whom have shown much enthusiasm for (but have at times shown antipathy toward)
market value accounting.15
14
Benston and Kaufman (1988), p. 36.
15
Benston (1989).
10
Whatever its advantages, there are reasonable objections to market value
accounting. Some examples may be found in the summary of comment letters on
the exposure draft of FASB 54:
"Those opposing market value for some or all financial instruments note:
(a) market value estimates are too subjective, (b) market value
estimates may not be comparable among entities due to differing
estimation techniques, (c) market value lacks relevance and is "stale"
information by the time financial statements are issued, (d) market
value estimates are difficult to verify, and (e) market value
information may be potentially misleading for the reasons noted in items
(a) - (d).'r
Since about half the respondents were financial institutions, it is fair to
say that there is some degree of skepticism regarding the promise held out by
market value accounting.
In addition, some feel that the costs of instituting market value
accounting may not be justified by the added usefulness of the result." That
is, it is not clear that it will be a particularly useful tool for bank
managers or source of information to the public.
As Benston (1982) has
pointed out, it is not the objective of historical cost accounting to report
economically meaningful values.
Rather, it is intended to establish control
over assets and operations as well as to meet regulatory and tax requirements.
In fact, explicit historical costs are probably more useful to auditors than
would be market values because of the ease of verification. That may in part
explain the lack of enthusiasm shown for market value accounting not just by
bank managers but by bank regulators as well.
Still, such objections might
argue against full adoption of market value accounting, but not against using
market values to determine capital and solvency.
Financial Accounting Standards Advisory Council (1988), p. 7.
16
17Cates
(1988).
11
Economists have also leveled objections to market value accounting.
In
particular, Berger et al. (1989) argue that there are different concepts of
market values of assets, in particular loans, that must be agreed upon if
values are to be comparable. For example, the value of a loan to the bank
that made it is likely to be different from the value of the same loan to
another bank or its liquidation value to the deposit insurer.
More
fundamentally, they argue that extending and holding loans that are by their
nature unmarketable is the raison d'etre of banks.
If commercial loans could
be readily marked to market, there would be no need for banks.
Any attempt to
mark such loans to market, therefore, would come up against informational
obstacles for which an entire class of institutions was created.
Such objections are consistent with practitioners' fears, cited above,
that market value estimates, at least of loan values, would in most cases be
unavoidably subjective and costly to compare and verify.
In contrast, book
values are at least objective. So while market value accounting would
eliminate obfuscation over differences between (objectively determined)
historical and (possibly subjectively determined) current values, it would
introduce new obfuscation over criteria for determining market value.
Thus
one problem would be replaced by another.
But even if there are difficulties and disagreements in arriving at an
estimate of market value, a reasonable market value estimate of capital should
provide a closer approximation to actual solvency than book values.
Objective
book values are not necessarily preferred to subjective market values if the
objective book values are irrelevant to whether a bank is solvent.
In essence, then, Berger et al. have established that market value
accounting would produce a less than optimal solution.
But along with the
12
practitioners, they fail to consider whether it would be an improvement over
historical cost accounting.'8
That is to say, the relevant choice is not
between market value accounting and some hypothetical ideal option, but rather
between market value accounting and the present system of regulatory
historical cost accounting. The case for market value accounting thus returns
to the matter of feasibility.
Is Market Value Accounting Possible?
There are two aspects to the feasibility of market value accounting.
First, market value accounting may be more or less suitable to financial
institutions than to other firms.
Second, various categories of assets and
liabilities of depository institutions are more difficult to value at market
than others.
And given the difficulties, some categories have a greater
quantitative significance as a proportion of a depository institution's
balance sheet.
It is this significance that helps determine where research
efforts should be focussed.
Can Market Value Accounting Work for Banks?
Benston (1982) has catalogued many of the discrepancies between economic
values and accounting numbers. A close look, however, shows that the
discrepancies are less for banks than for other types of firm.
For example,
book values of assets reflect purchase prices net of depreciation. But one
would expect a company to purchase an asset only if it expected it to be worth
more than it cost.
Assets are therefore understated. But for banks, the
amount lent is recorded as the book value, and it represents the amount
18 Although their policy recommendations are virtually identical to the
recommendations in the conclusion of the present paper. Their paper is by no
means a defense of book value accounting, but a "red flag" to those who
facilely assume everything can be readily marked to market.
13
expected to be paid back.
If such a loan carries adjustable interest rates
and is not expected to default, then book value should be a reasonable
approximation of market value.
Another discrepancy is nonrecording of assets.
For example, a contract
to provide a service represents an asset with an economic value, but is not
recorded as such except as income is received from it.
Since banks contract
to provide cash management and trust functions, they face the same problem.
But for banks the vast majority of contracts are loans, and loans are recorded
as assets.
So nonrecording of assets is less severe a problem for banks than
for other firms.
Finally, a major source of discrepancy between accounting and economic
values is changes in asset values. After a firm acquires a physical asset,
its book value is reduced over time by depreciation formulas.
used bear no relation to economic values.
The formulas
But banks have relatively few
physical assets, and the values of financial assets are not adjusted by
depreciation. While changes in default probabilities and interest rates do
lead to discrepancies between economic and accounting values of bank assets,
bank assets are at least free of even further distortions from economically
arbitrary depreciation adjustments.
Because the differences between economic values of bank assets and
liabilities and their corresponding accounting numbers are less than for other
types of firm, it is fair to say that market value accounting is more suited
to financial institutions than to any other type of firm.
This may also be
inferred from some empirical articles published in the early 1980s that
analyzed the usefulness of accounting rates of return for drawing economic
14
conclusions.1 9
The studies demonstrated the severe biases of accounting data
that arise from the difference in depreciation methodologies between firms and
the lack of relationship between accounting and economic depreciation. But
given the small proportion of bank assets comprised by physical capital (about
1.5 percent), the potential for such biases is small in banking relative to
most other industries.
In addition, studies attempting to develop profitability measures based
on actual cash flows imply that bank income data are a far more reliable
20
indication of actual cash flows than are income data from other industries.
For example, reported income flows from a bank loan would be more reliable in
calculating present values than would be income flows from, say, a
manufacturing company's assets.
As a result, market value accounting would
represent a less drastic change for banking than it would for other
industries. And because of the close correspondence between actual cash flows
and reported cash flows for banks, adoption of market value accounting would
have little effect on individual income statement items.
The major change
would be reporting adjustments to market values of assets and liabilities
between reporting periods.
The suitability of market value accounting for banks can also be
illustrated by contrasting it with its lack of suitability for public
utilities. In the late nineteenth century a controversy arose regarding the
appropriate base for public utility rates.
In 1898 the Supreme Court in Smvth
v. Ames held that
19 Fisher and McGowan (1983) and Benston (1985).
20
Salamon (1982).
15
"...the basis of all calculations as to the reasonableness of rates to
be charged by a corporation...must be the fair value of the property
being used by it for the convenience of the public. And in order to
ascertain that value, the original cost of construction, the amount
expected in permanent improvements, the amount and market value of its
bonds and stock, the present as compared with the original cost of
construction, the probable earning capacity of the property under
particular rates prescribed by statute, and the sum required to meet
operating expenses, are all matters for consideration, and are to be
given weight as may be just and right in each case. We do not say that
there may not be other matters to be regarded in estimating the value of
the property.... ,
While at first blush the Court's criterion might seem reasonable, in practice
it proved unworkable because of circularity: The market value of a regulated
public utility would depend on how much the firm would be allowed to charge
for its services, which the Court said should depend on market value.
The concept of market value was eventually superceded in practice by the
somewhat less objectionable concept of replacement cost.
But this concept had
its own problems. Replacement cost might be far higher than market value for
a specialized investment with actual cash flows below those required to yield
a positive net present value.
Put more simply, setting rates on the basis of
replacement costs could embody a sunk cost fallacy.
The choice between market
value and replacement cost was ultimately rendered moot in a 1944 decision
that recognized the circularity of the whole matter.2 2
The unsuitability of market value accounting for public utility rate
setting stands in marked contrast to its possible use for financial
institutions. In particular, banks do not have allowable rates of return or
administered rates for their products, so there is no problem of circularity.
2 1 SmYth v. Ames, 169 U.S. 466 (1898).
For a more complete discussion of
public utility rate setting, see Kahn (1970), pp. 35-41.
22
Federal Power Commission v. Hope Natural Gas, 320 U.S. 591 (1944).
16
Further, the lack of significant amounts of physical investment make the
question of replacement cost less pressing. Thus certainly relative to other
industries, market value accounting could work for banks.
How Would Market Value Accounting Affect Individual Balance Sheet Categories?
There are two dimensions to the feasibility of market value accounting.
One is the costliness of marking each category of asset or liability to
market.
Benston and Kaufman (1988) have considered this dimension by
surveying the depository institution balance sheet category by category in
order to determine how easily each item could be marked to market.
The other
dimension is the significance of each category as a percentage of total assets
or liabilities. This section will attempt to combine the two dimensions by
comparing the costliness of marking an item in a specific category to market
with its importance to the balance sheet.
Some assets and liabilities will present no problems for market value
accounting.
For example, assets or liabilities that are traded in active
markets can easily be reported at current values.
But it is also possible to
simplify marking untraded assets and liabilities to market by making two
assumptions:
first, fixed rate instruments with maturities of one year or
less have maturities of zero; and second, floating rate instruments with
repricing intervals of one year or less have maturities of zero.
As a result
of the assumptions, a significant portion of the balance sheet can be assumed
to be at market (assuming no deterioration in credit quality). While such
assumptions make accounting numbers less responsive to changes in interest
rates, they also make marking to market considerably less costly.
Liabilities. The largest single category of liabilities consists of socalled "core deposits," that is, checking accounts, NOW accounts, money market
17
deposit accounts, and savings accounts. As can be calculated from Table 1,
such deposits constitute over 70 percent of total liabilities for the smaller
categories of bank, but barely 40 percent for money center banks.
There are two possible approaches to valuing core deposits. On the one
hand, since they have a stated maturity of zero and can all be withdrawn on
demand, they could be assumed to be at market.
But since by definition core
deposits are not withdrawn frequently, their presence represents an asset to
the bank.
In order to reflect the value of the core deposit base, then,
Benston (1989) has suggested that the present value of the difference between
the rate paid and the market rate that would normally be required to attract
such funds be carried as an intangible on the asset side.
On the other hand, there is some evidence that the effective maturities
of core deposits are actually quite long.2 3
If this is the case, banks could
carry the present value of core deposits based on some empirically determined
maturity. But in practice the result should not differ much from carrying the
value of core deposits as an intangible. Further, the intangible approach is
more consistent with current accounting practices and should involve somewhat
less computation since it does not involve inferring effective maturities.
After core deposits, certificates of deposits (CDs) come next in
significance. About 90 percent of large CDs (over $100,000) have maturities
of less than one year.
Assuming that the same percentage of small CDs have
maturities of less than one year, then an additional 27 percent of liabilities
can be carried at market.
For longer term CDs (and, probably, subordinated
2 3 Flannery and James (1984).
In the limit, core deposits might be
considered perpetuities. But this would require an assumption that core
deposits are never withdrawn, which is totally unfounded.
18
debt), projected cash flows would have to be discounted at prevailing rates in
order to obtain a current value.
Federal funds purchased and repurchase agreements, both of which are
more significant for larger banks, could be assumed to be at market.
Virtually all deposits in foreign offices have maturities of less than one
year.
Finally, such liabilities as accounts payable and dividends declared
but not yet payable are carried as "other liabilities" and can probably be
carried at market.
Summing all the categories of asset that can be carried at
market, over 90 percent of liabilities may be assumed to be at market.
Securities. The simplest category of assets to mark to market is that
of marketable securities, since market values are readily available. In fact,
banks already report market values along with book values on their call
reports so market value accounting would require no more information than is
now the case.
Table 2 shows that investment securities comprise from
9 percent of assets in money center banks to 30 percent in small banks.
Securities in trading accounts are already reported at market values, although
trading accounts are just 4 percent of assets for money center banks and less
than 1 percent for other banks.
From the point of view of bank capital and
solvency, there is no reason to distinguish between securities in trading
accounts and those in investment accounts.
Table 3 shows that over 83 percent of securities held by most banks (and
over 90 percent held by small banks) are either federal government, agency,
state and municipal, or mortgage-backed securities, most of which are actively
traded.
And about one-third of money center bank securities are foreign
securities. The remainder consists of instruments such as corporate debt
19
securities, "strip" securities, investments in mutual funds, collateralized
mortgage obligations, and Federal Reserve Bank stock.
Some securities (including Federal Reserve Bank stock) held by banks are
not traded.
Most securities that fall into this category are small local
municipal issues or industrial revenue bonds.
Current regulations require
that if a security is rated but untraded, prices can be obtained from brokers
or from yield curve estimates.
If an untraded security is also unrated, then
a bank is allowed to carry it at amortized cost.
If the price of an issue were not available from brokers, then it could
be obtained in the same way as (hypothetical) market values of privately
placed, untraded corporate issues are provided by investment banks and
consulting firms.2 4
That is, the firms conduct regression analyses of
actively traded fixed-rate corporate issues in which spreads over, say,
Treasury Bill rates are obtained as a function of various characteristics of
the issuer and market.
Yield curve estimates are also factored in to account
for interest rate changes. The resulting information is used to assist money
market funds and pension funds in marking their portfolios to market.
The
methods could be applied to municipal bonds to provide market values by
pricing them according to how comparable traded issues are priced.
The practical significance of reporting securities at book rather than
market values may be inferred from call report data.
Table 4 shows that book
value of securities exceeded market value in 1984, 1987, and 1988, while
market value exceeded book in 1985 and 1986.
Conversely, return on market
value was higher in 1985 and 1986 but lower in the other years.
But the
provided by interviews with BARRA and Wilshire Associates.
See also Bond Valuation System, BARRA, 1989.
14information
20
percentage difference between book and market values was never more than three
percent, and the difference can go in either direction.
Further, the
difference between return on book value and return on market value exceeded 20
basis points only once during this period.
Given the small differences between market and book values, the effects
on capital of marking securities to market are also likely to be small.
A
simple example will give an idea of what would happen to capital if banks'
portfolios were marked to market.
In 1988, the book value of the average
bank's equity capital ratio was 6 percent while securities comprised
17 percent of its assets.
If banks had been required to mark their securities
to market in that year (in which book values of securities exceeded market
values by about 1.55 percent), equity capital for the average bank would have
decreased by about 4 percent of capital.
Suppose instead that the marking to market had occurred in 1986, when
market values were above book values. Assuming the same capital and
securities ratios as in 1988, equity capital would have increased by about 8.5
percent of capital. But it is likely that such differences, though small,
would be muted under market value accounting since banks would have incentives
to hold shorter-term securities that are less subject to interest rate
changes.
From a liquidity point of view, such a change would be desirable.
Physical assets.
Of greater difficulty than the preceding balance sheet
items would be physical assets such as premises and fixed assets.
It is
possible to rely on appraisals or possibly on actual market values, but the
problem with regard to such assets lies more in the expense than in the
conceptual difficulty of obtaining values.
But as Table 2 reveals, such
assets constitute between one and two percent of assets across size classes,
21
and are unlikely to be a major source of problems.
In fact, institutions
wishing to book gains on such assets without actually selling them might have
incentives to incur the costs of appraisals.
Alternatively, it would probably be less costly to obtain the
replacement cost of the asset based on costs of similar facilities, and this
could be used as the market value.
But using replacement cost would bring
back from the dead the ghost of a problem faced in public utility rate
setting: Of what relevance is replacement cost of an asset that in retrospect
yielded less than expected? It might be preferable, therefore, to use the
lower of replacement cost or appraised value in order to discourage attempts
to inflate reported capital.
Real estate.
Moving on to increasingly difficult assets, real estate
other than bank premises (known as "other real estate owned" or OREO) is
already carried at the lower of cost or market.
Specifically, current
regulations allow banks to carry such real estate at book values not to exceed
"fair values." While using such a standard is inconsistent with true market
value accounting, it has the advantage of limiting the ability of banks to
manipulate appraisals in such a way as to inflate their net worth.
Even if a market value standard were adopted, however, the ability to
inflate real estate values would be of limited help since other real estate
owned is not even one percent of assets for any size class of bank (Table 1).
And any attempts to use appraisals to inflate capital are likely to invite
close regulatory scrutiny.
It is more likely that auditors and regulators
will have to prod banks to write down those properties for which market values
are less than book values.
22
Intangibles. The thrift crisis has focused attention on the matter of
goodwill and intangibles. A glance at Table I shows that the significance of
recorded intangibles to commercial banks is minuscule. The largest proportion
of recorded intangibles is found in regional banks with assets over $1
billion, probably because of the premiums paid for interstate acquisitions.
And in the case of such institutions, the share amounts to less than one third
of one percent.
The problems lie with unrecorded intangibles. The difficulty of valuing
the intangible value of a core deposit base has already been discussed. But
there are other items of value to a bank that are not reflected on the balance
For example, the value of a branch network is not recorded as an
sheet.
asset, even though the network has economic value because it reduces
customers' costs of transacting with a bank.
Also, the name and reputation of
a bank, the employees' training, and the relationships between a bank and its
borrowers all have economic value.
Finally, the charter value of a bank is
likely to include the capitalized value of the deposit insurance subsidy.2 5
But the fact that intangibles exist and have market values does not mean
the values would be easy for the accounting system to capture.
There are two
possible ways such values could be ascertained. One is from acquisitions, in
which the difference between purchase price and recorded market value would
give an idea of the value of the intangibles. The other would be from the
difference between the price of an actively traded bank's stock and the book
value.
The problem is, most bank stocks are not actively traded, but are
instead held by a bank holding company.
Except in the case of bank holding
For examples of empirical analyses that attempt to uncover the value of
subsidies to risk, see Kane and Foster (1986) and Kane and Unal (1989).
25
23
companies in which the lead bank dominates and does not have extensive nonbank
subsidiaries, it might be difficult to attribute the intangibles entirely to
the bank.
Off-balance sheet items.
When a bank enters into a loan guarantee,
letter of credit, or other off-balance sheet item, it creates a contingent
liability since it may have to perform on the obligation. But it also gains
the right to collect the amount from the party receiving the guarantee.
Benston (1989) suggests booking the same amount on the asset side and
liability side.
If the bank does have to fulfill the guarantee, he calls for
booking the asset at the amount expected to be collected. While this has the
advantage of treating both on- and off-balance sheet items in a consistent
manner, it does little to reflect the actual risk that a bank (1) may have to
perform, and (2) be unable to collect fully from the guaranteed party.
It is
not clear how the asymmetry could be remedied unless accounting firms or
rating agencies could make some plausible judgments of the relative magnitudes
of risks on the two sides of the balance sheet.
So far no category of asset or liability appears to present insuperable
obstacles to adopting market value accounting. Over 30 percent of assets,
including securities (18 percent), cash (11 percent), and federal funds and
repurchase agreements (4 percent), present no problems.
Somewhat more
troublesome but of little significance are fixed assets (1.5 percent) and
other real estate owned, investment in subsidiaries, and intangibles (together
less than one percent).
Loans, however, present additional problems since by
their nature they are thought of as unmarketable. The following section will
consider how loans could be treated under market value accounting.
24
Can Loans Be Marked to Market?2 6
Loans constitute the largest asset category for banks regardless of
size, ranging from about 51 percent of assets for the smallest banks to over
60 percent for the large regional institutions. Thus biases between banks in
valuing loans may well be of concern. While little has appeared in the
academic literature about valuing loans, private sector practioners are
showing an increasing amount of interest in the subject.
The purpose of this
section is to bring together some of the knowledge developed so far.
Interest rate risk.
As mentioned previously, it is possible to simplify
marking loans to market by making two assumptions: first, that fixed rate
loans with a maturity of one year or less are at market values (assuming no
deterioration in quality); and second, that floating rate loans with repricing
intervals of one year or less are at market.
This was the approach used in an
early draft of a market value accounting proposal of a task force established
by the Federal Home Loan Bank Board (1982).
Table 5 shows the result of the assumptions: On average, 66 percent of
banks' loan portfolios can be considered to be at market values even under
current regulatory accounting procedures, at least as far as interest rate
risk is concerned. For the remaining 34 percent of loans, market values can
be determined by discounting the expected cash flows (adjusted for expected
prepayment of principal) at prevailing rates on comparable loans.
Credit risk.
It is not as simple to generalize about credit risk across
an entire loan portfolio as it is about interest rate risk.
But there are
Much of the information in the following section is based on interviews
with individuals at BULAN, Diversified Corporate Loans, Drexel Burnham
Lambert, KPMG Peat Marwick, Lafayette Group, Loan Pricing Corporation, NMB
Bank, and Salomon Brothers.
26
25
some exceptions. Both loans to individuals and real estate loans may be
relatively simple to mark to market values because experience has shown that
such loans have predictable default rates.
Just as expected cash flows from
the portfolio of consumer and mortgage loans can be adjusted for prepayments,
so can they be adjusted for expected defaults.
The significance of the
ability to approximate values for such loans is shown in Table 6.
Loans to
individuals are 12 percent and loans secured by real estate are 22 percent of
the average bank's asset portfolio.2 7
The major loan categories remaining are two:
(1) commercial and
industrial loans, and (2) all other loans, which includes loans to foreign
governments. The valuation of both is controversial, but only for commercial
loans is the art of valuation in its infancy.
Still, since commercial loans
are about 20 percent of the average bank's assets and other loans are almost
4 percent, the significance to capital calculations cannot be overlooked.
Loans without a secondary market.
Most commercial loans are not easily categorized into a small number of
borrowers.
Rather, they are dispersed among a large number of heterogeneous
borrowers ranging in size from major corporations to small neighborhood
businesses. Further, banks make loans on the basis of private information on
their borrowers. Consequently, commercial loans are not easily marketed and,
indeed, no true secondary market for commercial loans yet exists.
Loan loss reserves.
If market value accounting were adopted, valuation
of the commercial loan portfolio would stress net present values of expected
cash flows.
But in actual practice, loans might be treated in a manner
2 7 For an example of how to determine the market value of a fixed-rate
mortgage portfolio, see the Appendix to Kane and Foster (1986).
26
surprisingly similar to current GAAP practice.
At present, banks maintain
reserves (called allowance for loan and lease losses and carried as a contraasset account) to reflect anticipated losses. As losses are considered more
certain, they are charged off both the loan portfolio and the allowance,
although banks continue to attempt to recover the written off amounts.
While
loans net of reserves may not be consciously designed to reflect net present
values, they normally are a closer approximation to present values than are
book values.
Loan loss reserves are set by banks and audited by accounting firms and
regulators. Generally, auditors look closely at the largest loans
outstanding, past due loans, and loans to troubled industries, and determine a
prudent level of reserves for the loans.
They also examine samples of other
loans in order to generalize about the rest of the portfolio and determine an
overall reserve level.
In addition, bank regulators have guidelines linking
reserve levels to classified loans.
For example, the Federal Reserve Bank of
Richmond expects its member banks to set aside 10 percent of substandard
loans, 50 percent of doubtful loans, and 100 percent of loss loans as
reserves. An additional 0.5 percent of all loans is set aside as general loan
loss reserves.
The accounting industry is attempting to refine the methodologies they
use to determine loan loss reserve levels.
The most recent efforts rely on
expert systems (artificial intelligence) to capture the judgment process used
by auditors to arrive at an estimation of the quality of a loan.2 8
The system
asks a series of questions regarding exposure, liquidity, and past performance
28
Ribar, Willingham, and Bell (1989).
27
in order to estimate reserves.
The result of such an analysis on, say, a loan
classified as substandard might be to set aside reserves of 30 percent rather
than the required 10 percent.
While expert systems might provide more standardized criteria for loan
loss reserves than would auditors acting individually, they do not actually
attempt to ascertain market values.
Rather, they attempt to assemble the
knowledge and experience of professionals in what is an essentially
administrative procedure. Still, since auditors are acting as appraisers of
loans, using such methods as expert systems would be no less appropriate than
relying on appraisers to determine the value of assets that have not yet been
exchanged. And if reserve methodologies also sought to reflect interest rate
risk, the approximation to market values would be even closer.
Market-based alternatives. In contrast to administrative loan loss
reserving practices, market-based valuation methodologies would be based on
actual market data rather than on the opinions of an auditor or group of
auditors.
Such methodologies may take two forms:
matrix pricing and use of
actual market transaction data.
Matrix pricing classifies loans by characteristics, relates the
characteristics to yields, and then uses the results to infer discount factors
for comparable loans.
In fact, the method suggested for valuing untraded
municipal securities in the previous section is a form of matrix pricing (as
are hedonic pricing models used in housing economics). Once a discount factor
appropriate to a loan is determined, it can be used to find the present value
of the expected cash flow.
An example of matrix pricing may be found in the service provided by the
Loan Pricing Corporation (LPC).
LPC does not provide the facility for selling
28
loans nor does it market its service as a means of finding the present value
of a loan.
Rather, it assembles information that can be used by bank clients
to price the loans they are originating or renegotiating. As part of its
service, it has developed a model for estimating average loan rates.
The
model attempts to relate a rate, expressed as spread over prime or over Libor,
to such factors as "borrower size, risk, location, industry, loan type,
purpose, maturity," and other factors.2 9
The regression results are then used
to determine whether a particular loan is underpriced or overpriced relative
to the norm for loans sharing the same characteristics.
According to the author's interviews with LPC, it is also working on the
problem of assigning a present value to a floating rate loan.
generally yields a "normally" priced loan.
The LPC model
The solution LPC is currently
working on is to use the swap market to find fixed rate equivalents to both
the actual loan and the loan priced at the norm.
If the two fixed rate
equivalents differ significantly, the rate implied by the norm can then be
used to discount the cash flows from the actual loan and find a present value.
So far, the LPC approach has only been applied to higher quality
credits. While the rates implied by their model do take some account of risk,
the data assembled thus far have apparently not included nonperforming loans.
But as with untraded securities, using data on a large sample of loans to
infer rates with which to discount the cash flow on comparable loans may yet
be a promising approach to loan valuation.
In contrast to matrix pricing, using actual transaction data would have
the advantage of the informational efficiencies of a market and the discipline
29
Loan Pricing Corporation (1988).
29
on values provided by the arbitrage process.
But a market would be unlikely
to capture the private information banks have about their borrowers. To the
extent that some loans are suited to trading in a market, however, the
difficulties of administratively determining reserves for the other loans
would be reduced.
Loan securitization would provide a means of using market trades to
infer loan values.
It is considered promising because even if individual
loans cannot be marked easily to market, a portfolio of loans can be.3 0
So
far, banks have packaged mortgage loans, automobile loans, and credit card
receivables into marketable securities, but there has been very little
securitization of commercial and industrial loans.
If securitized packages of
commercial loans were traded, a bank could could mark its portfolio to market
by finding pools of loans reflecting comparable characteristics and applying
the pools' discount from face value to the bank's own portfolio.
In Canada there have been calls for commercial loan securitization. In
particular, the Economic Council of Canada (1989) has suggested that
securitization could be facilitated by greater standardization of commercial
loan terms.
In addition, differences in maturity and collateral could be
dealt with by including guarantees of principal and interest.
It remains to
be seen whether standardization of loans is consistent with banks' role as
specialists in private information about borrowing firms.
The seem to be some beginnings of a secondary market, although not a
market that is of help in marking loans to market.
Gary Gorton and Joseph
Haubrich (1990) describe the growth and characteristics of the loan sales
See, for example, Martin Mayer, "Marking to Market," American Banker,
December 11, 1987; and Benston and Kaufman (1988), pp. 80-81.
30
30
market now operating in the United States.
The market involves loan
participations sold by originating banks that entitle the purchasers to the
cash flow on the original loan.
loans.
Most participations are in floating rate
While the loans exchanged in the market were originally short-term
high quality credits, the market has broadened over time.
trading in the market is between the largest banks.
Still, most of the
Many of the loans sold
are participations in leveraged buyout loans, many of which are so large that
the originating banks would run up against loan limits if shares of the loans
were not participated out.
Ideally, the loan sales market would reveal discounts on loans to
specific borrowers that could be used to determine loss reserves.
But actual
transactions involve sales of loans at book values, although the selling bank
retains a part of the fee and interest income passed through to the buyer.
Thus there is no discount that can be used to mark to market.
In essence, the
buyer would have to establish its own reserves on the purchased loan if
problems were to arise.
And it is not clear that the market has a broad
enough base of participants to be of help to the majority of banks in the
United States.
Finally, some participations cannot be resold, so there would
be no continuing revaluation of particular loans.
In sum, the loan sales
market does not yet appear to represent a fully functioning secondary market.
Outside of the loan sales market, there have been few applications of
commercial loan securitization. To give an example of one application, Drexel
Burnham Lambert in 1987 claimed to have "designed an offering package that
would allow a bank to sell its nonperforming loans to investors at a deep
31
discount."'3 '
But the main result thus far has been the so-called Mellon "bad
bank" (or, more properly, Grant Street National Bank) deal in which Mellon
sells its nonperforming loans to an organization created for that purpose
alone.
Drexel apparently went through the portfolio loan by loan and
developed projected cash flows.
They then designed a bond issue that could be
supported by the cash flows.
It seems inescapable that a truly reliable market valuation must involve
continuing analysis of expected cash flows as was performed by Drexel.
But
given the large number of loans in many banks' portfolios, computing
discounted cash flows for each transaction might prove to be a complicated and
costly undertaking.
Still, there are tax advantages once the marked-down
portions of the loans are charged off.
In general, the Drexel approach
suffers from the same problem as does setting loan loss reserves and, for that
matter, matrix pricing:
It tries to estimate what loans would be worth in a
market that does not yet exist.
While actual examples of commercial loan securitization are few, some
firms are seeking to create an active market for loans. For example,
Diversified Corporate Loans, Inc. (DCL), formerly Dimensional Corporate
Finance, has been attempting for several years to set up a tradable pool of
commercial loans.
Essentially, DCL has been trying to establish a system
whereby banks could sell commercial loans into a pool.
Prices are based on a
spread over commercial paper, and are determined by a survey of pool
participants' assessment of risks.
Loans are then sold without recourse into
the pool, which consists of loans of similar quality and maturity. Buyers
3 1 "Banks Increasingly Sell Parts of Their Loan Portfolios," Wall Street
Journal, March 4, 1987.
32
then purchase a "proportional interest," that is, a fractional interest in
each loan in the pool.
A bank selling a loan receives the equivalent value of
proportional interest.
Such a pool could provide a means for valuing commercial loans, since it
combines loans of similar quality and maturity. But DCL has been criticized
for the limited scope of its idea.3 2
Specifically, the first portfolio
offered will consist of investment-grade (that is, highest quality) loans
maturing in 183 days or less.
Because the loans are short term and of high
quality, however, there is likely to be little if any difference between book
and market values.
And such difference as does exist may not be worth the
cost of determining. Thus it is not clear how much guidance will come from
DCL's pool.
It is possible, however, that the major contribution of DCL if it
succeeds will be not so much in the information it provides but rather in
developing a facility through which loans may be exchanged.
So while it may
not be of assistance now in marking to market, the facility over which DCL
conducts its transactions may eventually provide a means for marketing loans
of a wider range of quality.
A more recent and promising entry is related to an attempt by the
Lafayette Group to set up a "bankers' bank."
One of the planned functions of
the bankers' bank would be to purchase nonperforming commercial loans.
It
could also involve a secondary market in which commercial loans could be
bought and sold.
In particular, they hope to "standardize the sale of these
"Bankers Calling Loan-Pooling Program Too Limited," American Banker,
September 9, 1989.
32
33
loans in order to find their true value."3 3
Their model would estimate
variances of cash flows as a function of characteristics of the underlying
source of the cash flows, macroeconomic variables, collateral, and other
factors such as workout strategies. The valuation procedure would then
project expected cash flows for each loan and adjust them for their estimated
variance.
Along with the market would come the ability to package and securitize
commercial loans.
Even though the original intent of the bankers' bank was to
purchase nonperforming loans, the securities issued by the bank could include
both performing and nonperforming loans.
But it is unlikely that the
securitized packages would be of much help to banks in computing loan loss
reserves because the packages would probably contain far higher proportions of
nonperforming loans than would be the case for any solvent bank.
The
important contribution would be from the market loan trading facility.
The market would be modeled after BULAN's Mortrade data base that is
already used for trading mortgages.
The Mortrade system is essentially an
informational network over which sellers can make known what types of loans
they are offering and buyers can make known the types of loans they are
looking for.
Actual transactions can then be consummated either over the
network or off-line. The information available over the network could be
useful in marking a mortgage portfolio to market because a depository
institution could search a network for a pool of mortgages comparable to its
own portfolio.
33
1989.
The pool's price, normally expressed as a discount from face
"'Bankers' Bank' Would Securitize Bad Assets," American Banker, June 6,
34
value, could then be used to get an approximate discount for the institution's
own portfolio.
The bankers' bank would take the BULAN concept one step further by
turning it into a network over which sales are actually consummated, thereby
yielding quotes on loans and pools in a manner similar to that found on the
NASDAQ network for over-the-counter stocks.
It is hoped that if the terms of
commercial loans can be standardized and that the necessary items of
information communicated on the system, then participating banks will be able
to enter the system to either buy or sell and will be able to gain a fairly
accurate idea of what their loans would fetch.
The Market for Loans to Less DeveloDed Countries.
One area that holds out promise for the ability to mark loans to market
is the growing market for loans to less developed countries (LDCs).
While
loans to LDCs may not be a significant percentage of assets for the vast
majority of banks, they are significant for a few.
Table 7 shows the extent
of LDC debt exposure for the sixteen largest banks in the United States as of
In addition, a survey has shown that if the ten largest bank holding
1988.
companies in the United States had been required to mark their LDC loans to
market values at least one bank's capital would have been virtually wiped out
while the other banks would have recognized substantial losses.3 4
Given the
potential effect of the change, then, marking LDC loans to market remains
controversial.
LDC loans seem well suited to a secondary market because they are to a
fairly small and easily distinguished group of borrowers. Further, each has a
"Third World Debt Cures Are Bitter Pills for Big Banks," American
Banker, October 5, 1988.
34
35
large enough volume outstanding to make trading worthwhile. But as recently
as 1985, Edward Kane lamented the lack of such a market and attributed the
lack to regulators' unwillingness to recognize the risks faced by banks
lending to LDCs." Since Citicorp made its now famous LDC loan loss reserve
increase in 1987, however, the market has become more active and more highly
developed.
Today, brokers in the secondary market include Nederlandsche
Middenstandsbank (better known as NMB Bank), Salomon Brothers, Merrill Lynch,
Citicorp, First Chicago, and Chase, to name just a few.
In all, ten firms are
considered major brokers, which take positions in most or all LDCs' debt; ten
more are "niche" brokers, which specialize in a country or region; and three
are "brokers' brokers," which do not take positions but help match buyers and
sellers for specific transactions. Both Salomon and Merrill publish secondary
market price quotations, usually on a biweekly basis.
While there are no
published volume figures, analysts seem to agree that annual volume ranges
from about $40 billion to $60 billion.3 6
Since 1987, banks have participated extensively in the LDC loan market.
Many regional banks, especially those in the Middle Atlantic and Southeast,
used the market to drastically reduce their LDC loan exposure.
According to
one observer, $15 billion of debt has been eliminated from bank balance sheets
in the United States through the market.3 7
The most frequent means of
reduction has been selling the loans in the market.
The most recent example
Kane (1985), p. 125.
35
36
Information provided by the author's telephone interviews with at
Salomon Brothers and NMB Bank.
37
Interview with Peter Geraghty, NMB Bank.
36
is NCNB Texas selling its entire portfolio of Mexican loans in Spring 1989.38
Despite the activity in the market, the validity of secondary market
quotations for LDC loans is not universally accepted.
For example, when the
General Accounting Office issued a report recommending that loan loss reserves
for LDC loans be increased to levels consistent with secondary market
prices,3 9 the bank regulatory agencies responded that the market is thin, that
the prices are biased by debt-for-equity and debt-for-debt swaps, and that in
setting reserves market prices are no substitute for the judgment of "trained
and experienced professionals," that is, examiners.
Further, the Federal
Reserve's response included a reaffirmation of the doctrine of ultimate
collectibility in that "the market price may not reflect the ultimate value of
a loan held to maturity."4 0
There seems to be some skepticism about whether secondary market prices
reflect the "underlying value" of the loans.
A typical quote:
"The market price reflects the value of only one kind of debt--the
generic, illiquid paper that banks hold in abundance. It is a
'distress' price for creditors simply looking to rid themselves of their
burdens, based less on economic fundamentals than the perceived
political climate. a41
The quote apparently means that LDC loans are sold at prices below the net
present value of the expected cash flows.
But to suggest that such "fire
sale" prices would persist over time is to dangle some delicious arbitrage
"NCNB Texas:
1989, p. 35.
38
39
40
The Fastest Liquidator in the West," Latin Finance, May
U.S., General Accounting Office (1988), pp. 25-30.
Ibid, pp. 62-68.
"''Black Market' Gives Big Banks an Edge in Debt Sales," American
Banker, March 8, 1989. See also "Anomalous but Profitable," Euromoney,
January 1988 (supplement).
41
37
opportunities before market participants, opportunities that should be
eliminated by the incentives of the participants to take advantage of them.
Another problem pointed out by the regulatory agencies is that debt
prices may be biased by exchanges of the debt of one LDC for that of another
In either case the original
or for equity in firms in the borrowing country.
debt could be taken off the balance sheet at prices above secondary market
cash prices.
In addition, some money center banks may report a higher selling
price (and book a lower loss) by selling debt along with access to a relending
program at a borrowing country's central bank.
Each of these artifices will
be considered in turn.
Debt-for-debt swaps do not contradict the validity of secondary market
prices.
On the contrary, such swaps are geared to secondary market prices in
practice.
For example, assume that Mexican debt trades for 42 cents on the
dollar of face value on the secondary market, while Brazilian debt trades for
30 cents on the dollar.
A bank may swap $10 million (face value) of Mexican
debt for $10 million (face value) of Brazilian debt, and in the process would
receive $1.2 million cash since the bank giving up Brazilian debt has received
assets it could sell for $1.2 million more on the secondary market.
Under
current accounting practices, the selling bank would book no loss on the debt,
and in fact would add to its cash.
The point is, both banks' actions involve
a conscious recognition of the validity of secondary market prices no matter
what the accounting treatment of the transaction.
Debt-for-equity swaps present another set of problems.
In a typical
transaction, a bank takes its LDC debt to the borrowing country central bank
and exchanges the debt for the local currency at the official rate on the
understanding that the currency will be used for equity investment. The bank
38
then buys equity in a local firm.
The debt may have been converted at face
value or at a discount, but the discount is probably less than would have been
realized had the bank sold the debt for cash on the secondary market.
Thus
the bank avoids writing the debt down to secondary market levels as would have
been required after a sale in the market for cash.
Under current accounting practices, debt-for-equity swaps may enable
banks to avoid (or, more likely, postpone) recognizing their true losses.
Since market value accounting would require losses to be immediately
recognized, there would be less incentive to use debt-equity swaps to avoid
writedowns.
But even under market value accounting, there could still be obfuscation
of losses by means of debt-for-equity swaps.
For example, a bank need not
swap debt in its own portfolio. Instead, it can buy the debt on the secondary
market and then go through the same swap.
As in the previous example, the
central bank of the borrowing country would convert the debt to the local
currency on favorable terms and the currency would be invested in local
equities. The bank would profit by the spread between the value of the debt
and that of the equity, a spread that is enlarged by the implicit subsidy from
the central bank's conversion at a favorable rate.
The problem in such transactions is not bias in secondary market debt
prices, but how to account for the value of the equity.
Indeed, debt-for-
equity swaps might be open to manipulation so "the value of [borrowing country
firm] equity is whatever their accountants say."4 2
On the one hand, if the
equity is traded in an active secondary market, it can be marked to market on
42
Ibid.
39
the bank's books after adjustment for exchange rates.
On the other hand, if
the equity is not actively traded, accounting treatment will be difficult.
A solution would be to require a bank to mark the value of the untraded
equity down to the lesser of (1) the secondary market value of the debt
swapped for the equity or (2) the estimated value of the equity.
The former
would reduce the ability to overstate equity values because of subsidies from
borrowing countries. The latter would be necessary if the firm in which the
equity is held were to go bankrupt or otherwise fail to meet expectations.
Finally, selling debt along with access to a relending facility in
reality constitutes selling an intangible asset in addition to debt.
In an
accounting sense, the sale of the intangible is reflected entirely in the
selling bank's charging off a lower percentage of the original loan than the
secondary market price might imply.
But it does not follow that the higher
reported sale price implies that secondary market prices are biased estimates
of the net present value of the expected cash flows.
Apparently, banks do accept the validity of secondary markets in
practice.
For example, a survey by the Federal Reserve Bank of Richmond
revealed that NCNB, First Wachovia, First Union, and Crestar all used the
secondary market to eliminate most or all of their LDC exposure.
It seems
unlikely that such institutions were under any pressure to sell at "fire sale"
prices or to otherwise sell out for less than they felt their holdings were
worth.
It is far more likely that when money center banks report sales of LDC
loans at prices above market, they should be viewed with caution.
The notion of a thin market is harder to refute.
While the market for
most countries' debt may see issues change hands every day, transactions often
occur in large lumps for two reasons.
First, when a bank reduces its exposure
40
by selling debt, the transaction can be quite large relative to the market.
Second, debtor nations themselves may engage in transactions that affect the
amount of debt outstanding. For example, an LDC with a debt-for-equity swap
program may allow some debt to be converted during a limited period.
So
rather than having a large number of transactions offset each other, the
pressure on price at a particular time often occurs on just one side.
Consequently, bid-offer price spreads might diverge significantly, at least
temporarily.
A look at the price movements of LDC debt my shed some light on the
question of thinness. Charts A through F show bid and offer price movements
since 1987 for six of the most actively traded LDC borrowers, Argentina,
Brazil, Chile, Mexico, Venezuela, and Yugoslavia. Significant movements in
the prices occur after the Brazilian debt moratorium in early 1987 and the
Citibank reserve increase in the spring of 1989.
It is safe to say that the
market reflects the increasingly pessimistic outlook for LDC debt.
In addition, Charts G through L show the behavior of the bid-offer
spread for the countries' debt over the same period.
While the spreads are
sometimes substantial, the charts show that they do not persist.
Rather, the
evidence suggests the spreads are volatile (at least compared with such highly
developed markets as those for stocks and bonds) because of the relatively
small number of transactor and their size in relation to the market.
But
since the spreads quickly disappear, it is reasonable to infer that the
arbitrage process is at work.
Further, it should be noted that the prices are "indicative" prices
rather than records of actual trades.
That is, they are based on surveys of
what prices participants are willing to accept.
But in practice spreads tend
41
to be lower since the participants might actually accept a higher bid price or
lower offer price than they are willing to reveal before an actual trade.
Arbitrage is the main reason secondary market prices are likely to
provide a reliable means of marking to market.
If the market were to
consistently underprice (or overprice) issues, one could profit by taking a
position contrary to the market.
Further, with 23 active brokers, 20 of which
take positions in some or all of the debt, characterization of the market as
thin seems misplaced. Given the development of the market, there remains
little justification for rejecting secondary market prices for marking LDC
loans to market.
What Should Be Done?
Three points should follow from the above analysis.
First, with regard
to capital and solvency regulation, market value accounting promises an
improvement over historical cost accounting. Second, determining market
values will require close analysis of expected cash flows, and that will in
all likelihood be far more costly to firms than current practices.
Third,
loans are the only significant category of assets that would be difficult to
value.
But in practice, loan loss reserves might actually be set in a manner
similar to that used in current value accounting.
There is no practical reason some balance sheet items could not be
carried at market values immediately. Many, such as unimpaired floating rate
loans and short term liabilities, can be assumed to be at market values.
Securities and loans to less developed countries have active markets in which
market values are readily available. For long-term fixed-rate loans and
liabilities, however, it would be necessary to use discounted expected cash
flows to approximate market values.
While doing so would be costly to the
42
firms involved, it would have the offsetting benefit of providing far more
accurate information regarding the deposit insurance funds' potential exposure
to losses.
Market value accounting could be adopted in phases.
The first phase
would involve carrying all marketable assets at market values.
The second
phase would then extend market value estimation to other balance sheet items.
Such a schedule would provide an impetus for accelerating the development of
secondary markets and securitization of commercial loans.
Even if market value accounting is rejected this time around, the fact
that there are moves toward commercial loan securitization and a secondary
loan market means there will be less and less justification for maintaining
the status quo.
Securitization makes sense for reasons unrelated to market
value accounting, but the knowledge it provides will make market value
accounting more feasible. And as banks have more exposure to institutions
that deal in market values, their squeamishness about market value accounting
will likely decrease.
43
REFERENCES
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Bulletin (Spring 1982): 161-215.
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"Market Value Accounting by Banks: Benefits, Costs and
Incentives." Proceedings of a Conference on Bank Structure and
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_
Benston, George J., and George G. Kaufman. "Regulating Bank Safety and
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Benston, George J., Robert A. Eisenbeis, Paul M. Horvitz, Edward J. Kane, and
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Berger, Allen N., Kathleen A. Kuester, and James M. O'Brien. "Some Red Flags
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Bank Structure and Competition, Federal Reserve Bank of Chicago, 1989.
Board of Governors of the Federal Reserve System. "Revision in Bank
Examination Procedure and in the Investment Securities Regulation of the
Comptroller of the Currency." Federal Reserve Bulletin 24 (July 1938):
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Cates, David C. "Bank Credit Quality in a Restructured Financial System."
American Banker, April 13, 1988.
Economic Council of Canada. A New Frontier: Globalization and Canada's
Financial Markets. Ottawa: Economic Council of Canada, 1989.
Federal Deposit Insurance Corporation. "Development of Uniform Examination
Procedures among Federal and State Bank Supervisors." Annual Report of
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31. 1938, pp. 61-78.
Federal Home Loan Bank Board. "Revised Report of the Interoffice Task Force
on Market Value Accounting," October 8, 1982.
"Report of the Expanded Task Force on Current Value Accounting,"
April 12, 1983.
_.
44
Financial Accounting Standards Advisory Council. "Comment Letter Summary,
Test Application Notes and Project Status--Financial Instruments
Disclosure." Memorandum, Financial Accounting Standards Board, July 26,
1988.
Financial Accounting Standards Board. ProDosed Statement of Financial
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Fisher, Franklin M., and John J. McGowan. "On the Misuse of Accounting Rates
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82-97.
Flannery, Mark J., and Christopher M. James. "Market Evidence on the
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Hempel, George H., Donald G. Simonson, Marvin Carlson, Marsha Simonson, and
Marcia M. Cornett. "Market Value Accounting for Financial Service
Companies." National Center on Financial Services, University of
California, Berkeley, 1989.
Johnson, Ramon E., and Paul T. Peterson. "Current Value Accounting for S&Ls:
A Needed Reform?" Journal of Accountancy, January 1984, pp. 80-85.
Kahn, Alfred E.
The Economics of Regulation, vol. 1.
New York: Wiley, 1970.
Kane, Edward J. The Gathering Crisis in Federal DeDosit Insurance.
Cambridge, Massachusetts: MIT Press, 1985.
Kane, Edward J., and Chester Foster. "Valuing and Eliminating Subsidies
Associated with Conjectural Guarantees of FNMA Liabilities." Ohio State
University, May 1986.
Kane, Edward J., and Haluk Unal. "Valuing Structural and Temporal Variation
in the Market's Valuation of Banking Firms." Journal of Finance
(December 1989, forthcoming).
Loan Pricing Corporation. "Loan Pricing Matrix."
Technical paper 11-88,
1988.
Ribar, Gary S., John J. Willingham, and Timothy B. Bell. "The Auditor's
Evaluation of Commercial Loans." New York: KPMG Peat Marwick, 1989.
Salamon, Gerald L. "Cash Recovery Rates and Measures of Firm Profitability."
Accounting Review 57 (April 1982): 292-302.
45
U.S. General Accounting Office. Supervision of International Lending is
Inadequate. Report to Congressional Requesters. GAO/NSIAD-88-87. May
1988.
White, Lawrence J. "Mark-to-Market Accounting is Vital to FSLIC and Valuable
to Thrifts." Outlook of the Federal Home Loan Bank System 4
(January/February 1988): 20-24.
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TABLE 7
1988 LDC EXPOSURE: LEADING U.S. BANKS
(percent)
LDC Loans/
Assets
Bank
Citicorp
Chase Manhattan Corp.
Chemical Banking Corp.
Bankers Trust Co.
JP Morgan & Co.
Bank of New York
Manufacturers Hanover
First Chicago Corp.
Continental Bank Corp.
BankAmerica Corp.
First Interstate Corp.
Security Pacific Corp.
Wells Fargo & Co.
Mellon Bank
Republic New York Corp.
Marine Midland Bank
Source:
5.83
8.11
9.04
6.90
5.48
3.15
12.29
4.73
4.91
9.51
1.02
0.67
0.53
3.80
1.80
5.78
Latin Finance, May 1989.
LDC Loans/
Equity
Reserves/
LDC Loans
122.67
159.27
153.44
114.33
79.61
53.50
251.15
88.64
93.46
216.92
26.52
13.53
9.50
93.42
30.93
127.23
23.55
25.32
20.85
NA
NA
40.00
20.73
43.33
50.07
27.78
52.00
58.00
60.00
47.42
NA
46.07
NA means not available.
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