Sunday, November 18, 2012

No Security in Book Value

Said a banker: "The Crisis revealed,
In investments we carried for yield,
How extreme fluctuations
Affect valuations,
So better to keep them concealed."

Said investors: "It's better to trust
In the price you could fetch if you must,
And the equity value
Which, hopefully, now you'll,
Accordingly, have to adjust."

Bankers, regulators, lobbyists and the US Congress have all turned their attention to the US implementation of the Basel III regulatory framework, which appears to have very few friends in high places. One always-controversial element of Basel III is the requirement to mark to market those securities that a bank has as "available for sale." Bankers hate this idea because it increases the reported volatility of earnings and capital. At a Senate Banking Committee last week, Michael S. Gibson, director of the Division of Banking Supervision and Regulation at the Fed, appeared prepared to give a little in the face of industry pushback, saying that regulators are "considering changes to the treatment" of such securities.

However, if bankers hate mark-to-market, investors should love and defend it. As the Journal's Heard on the Street columnist David Reilly writes: "the only thing worse than a loss at a big bank is pretending it doesn't exist." Reilly points out that available-for-sale securities comprised $2.6 trillion, or 19% of bank assets, on June 30, up from 14% in 2008. Like it or not, such investments do fluctuate in value, and pretending that they could be disposed of at cost only leads to investor distrust during financially difficult times. Unlike bank loans, liquid securities are not reserved against, so marking them to market is the only way to assure that, at least in this one respect, investors can place some credibility in the reported book value of financial institutions.

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