"Challenge On Bank Assets" - DJ Newswire, 11-02-07 -
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Judging by the latest crop of banking results, there's little doubt the audit profession faces an uphill task in the future.
They are used to judging the financial condition of a corporation based on accounting entries and associated trails of paperwork.
But the financial condition of banks, especially those with investment banking operations, are increasingly linked to assets whose value depends on in-house pricing models.
Under accounting standards SFAS 157 and 159, set by the Financial Accounting Standards Board (FASB), U.S. banks will be obliged to reveal the hierarchy of those assets from Nov. 15. They will be marked Level 1, 2, 3 according to the ease of valuing them. Some investment banks have already started doing it.
Similar standards are already in place in Europe under IAS 39 and IFRS7.
Level 1 asset valuations pick market prices, level 3 assets are illiquid and lack observable market prices while level 2 assets fall between the two.
It's the level 3 assets that must concern investors more than ever as they are marked to in-house models. Those models are more art than science and are subject to the banks' judgment.
Much of the attention of such Level 3 assets has been focussed on mortgage-related assets. But they also include complex derivative contracts, credit card receivables, loans linked to leveraged buyout loans and asset backed commercial paper.
Solvency risks apart, the assets have liquidity risks that need to be assessed. This is where auditors need to get tough and need tools to play devil's advocate. And regulators need to ensure auditors are providing independent judgment on these valuations.
The two German banks that have suffered the most - IKB Deutsche Industriebank and Sachsen - due to exposure to asset-backed securities vehicles disclosed little about liquidity risk, much to the surprise of accounting standard setters. This despite IFRS7's, which went into effect in January 2007 in Europe, asking for detailed disclosure on complex financial instruments.
Obviously the auditors - KPMG for IKB and PwC for Sachsen - were not tough enough on disclosure.
From Nov. 15, the Level 3 disclosures will be accompanied by details of the basis on which they are classified. It's the auditors job to be vigilant about whether the right inputs to value Level 3 assets are used.
Third-quarter numbers show some investment banks have such assets that are either equal or greater than shareholders' equity.
In terms of book value of equity, some U.S. investment banks that don't have the cushion of private or commercial banking businesses show some revealing numbers. Bear Stearns' $20 billion is 50% more than its shareholders' equity. For Goldman Sachs it's nearly twice its equity.
In Europe, Swiss bank UBS's Level 3 assets at Q3 stood at 6% of its total assets. That's $129 billion. Even if 10% of that is written off, the post-tax result is still equal to 10% of UBS' current market capitalization.
That's why investors should be more concerned about not just the amount - it's not necessarily a bad thing to have level 3 assets - but also about the quality of disclosure. And whether the models used include as many inputs as possible.
Financial regulators should ensure that the auditor validations are made public in adequate detail.
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