Mayra RodrÃguez Valladares is managing principal at MRV Associates, a capital markets and financial regulatory consulting and training firm based in New York. She is also a faculty member at Financial Markets World and the New York Institute of Finance.
The fact that Bank of America neglected to correctly account for certain structured notes that it inherited when it took over Merrill Lynch should not have surprised the market. And it raises the question of what other bad news may be coming from the big banks.
There were several signals before this week that Bank of America and large banks might be having problems. First, structured products â€" whose eventual value at maturity varies based on the performance of something else, like a currency or stock index â€" are challenging to value. The more complex they are, the harder it is to even find data to properly value them and to measure their credit, market, operational and liquidity risks. Anyone who claims that valuing structured products and measuring their risks is easy is being blinded by the chase for yield.
In mid-January, Sarah J. Dahlgren, executive vice president of the Federal Reserve Bank of New York and chairwoman of the Senior Supervisory Group, wrote to the Financial Stability Board summarizing a study on banks’ exposure in a range of financial transactions with counterparties. The study, she said, found that ‘five years after the financial crisis, firms’ progress toward consistent, timely, and accurate reporting of top counterparty exposures fails to meet both supervisory expectations and industry self-identified best practices.â€
Ominously, the study found that the “area of greatest concern remains firms’ inability to consistently produce high-quality data.†If banks cannot monitor counterparties and produce high-quality data, it is unlikely that they understand the true nature of their risks.
And in February, the board of governors of the Federal Reserve System announced a list of systemically important banks that could begin to publicly report their capital ratios under the advanced approach. This methodology allows banks to use their own internal data on probabilities of default and severity of losses to calculate their risks. Bank of America was conspicuously absent from the list. Typically, if a bank is not allowed to report under the advanced approach, it is experiencing challenges with corporate governance or internal controls or having problems collecting, aggregating and calculating data correctly and consistently.
Given the size and complexity of these big banks, there is no such thing as a small error. Bank of America’s accounting error led it to overstate its capital levels by $4 billion.
If Bank of America took five years to discover the true nature of its exposure to risk in structured products from Merrill Lynch, then what about the other big banks? Do they have strong enough management of their risks and good internal controls to detect accounting problems? Especially with structured products, it is worth analyzing whether the auditors â€" both internal and external â€" are getting enough information on how the banks value and measure their risks.
Given that Bank of America now has to resubmit its capital plan to the Fed, the market is likely to have even less trust in the Fed’s annual review of big banks’ capital plans.
Nor is that the only fallout. Bank of America’s problems also raise questions about the reliability of the large banks’ living wills â€" the reports that the banks submit to the Fed and the Federal Deposit Insurance Corporation explaining how, if they were to fail, they would be resolved in an orderly manner. Writing the living wills has been incredibly challenging for banks because they must have a deep comprehension of their institutions and understand where their risks lie. To do that, they need high-quality data.
The challenge for the Fed and the F.D.I.C. is huge. If the regulators were to discover that banks’ living wills were not credible, they would then be supposed to issue deficiency notices to banks and force the banks to rewrite the wills. But disagreements could arise between the Fed and the F.D.I.C., or even inside each regulator, as they tried to find a balance between making sure the banks were on firm financial ground and demanding too much of the banks.
And as soon as the market heard that banks had to rewrite their living wills or that a deadline for delivering a living will was extended, the markets would react to that, possibly aggravating the bank’s financial condition. And what if a bank received a vague deficiency note from regulators, possibly as soon as the next few weeks? Bank officials would struggle to figure out what to do, since some living wills for 2014 are already due this summer.
Complicating matters further, both for banks and regulators, is that there are many unsettled issues in the resolution process outlined in Dodd-Frank. If a legal banking entity failed, for instance, it is not clear how much its parent would have to do.
Regulators also fear that in trying to resolve a bank in an orderly manner, there could be a fire sale on repurchase agreements. Counterparties in a derivatives contract would probably rush to the failing institutions seeking to terminate their contracts, similar to what happened in the collapse of Lehman Brothers in 2008. That would aggravate the failing bank’s situation even more. An additional problem and one of the biggest challenges would be cross-border issues with foreign regulators.
Dodd-Frank’s main objective for living wills is to reassure the market that a bank can be resolved without a government bailout. Until banks are more transparent and living wills are made public, the market is buying banks’ bonds and stocks on faith.
