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Bank Balances Shift With Rule Changes
After One Tweak Improved the Books, Another Could Erase Gains and More

By Binyamin Appelbaum
Washington Post Staff Writer
Wednesday, August 5, 2009

A controversial change in accounting rules earlier this year has allowed banks to claim billions of dollars in additional earnings simply by tweaking their bookkeeping, greatly enhancing the appearance that the industry is returning to health.

A study by an accounting expert found that 45 financial firms reported higher first-quarter earnings because of the change. The total benefit exceeded $3 billion. Some large firms, including Prudential Financial and Bank of New York Mellon, were able to report profits rather than losses.

But accounting rulemakers are considering further changes that could drain the blood right back out of the industry, potentially forcing banks to acknowledge paper losses even larger than the new windfall of paper gains.

The proposal has put a spotlight on the Financial Accounting Standards Board, the obscure nonprofit that sets bookkeeping rules for U.S. companies, highlighting the extent to which important changes in financial regulations may be decided off Capitol Hill.

It also has sparked the latest round in a long-running battle between investors eager for more information about the financial health of banks and companies eager to retain control over their image and the information they present to investors.

The debate is not just about cosmetics, however. In setting the rules that investors use to assess performance, the accounting board also exerts important influence on the way that banks do business, with ramifications for the broader economy.

The proposal, which the standards board will consider issuing for comment later this month, would require banks to report the value of all loans and other assets based on the prices that buyers are willing to pay. This process is called marking to market, and the result is called a fair value. At present, banks are not required to report the fair value of most loans. They can instead report a value based on the original purchase price.

Some investors and accounting experts think the change would make it harder for banks to conceal problems from investors.

"Usually when someone says that something is a big deal in accounting it's because it's going to increase profits or decrease profits, and this is not going to do either. But this is still a big deal," said Jack Ciesielski, publisher of The Analyst's Accounting Observer. "It's going to show investors how much assets are worth."

Banking executives and industry groups, however, have responded to the proposal with shock and consternation. They say that banks would be forced to record large declines in the value of loans, then set aside large sums to cover the implied losses, tying up money that might otherwise support new lending.

Industry Raises a Fight

Some industry groups warn privately that they will press Congress to intervene if the standards board moves forward with the proposal, which could trigger a broader fight over the board's future. Right now, the accounting board answers only to the Securities and Exchange Commission. But others increasingly have sought to influence the board, including members of Congress, banking regulators and banking trade groups.

The Financial Crisis Advisory Group, an expert panel commissioned by the accounting board to advise its decisions, said in a report last week that its members were "increasingly concerned about the excessive pressure placed on the two Boards" FASB and its international counterpart, the International Accounting Standards Board, "to make rapid, piecemeal, uncoordinated and prescribed changes to standards."

"It is essential that policymakers respect the independence of the standard-setting process," the report said.

Defenders of the board's independence were outraged this spring when lawmakers all but ordered the financial standards board's chief, Robert Herz to make changes sought by the banking industry during a contentious hearing on Capitol Hill. One change softened the impact of when short-term investments such as securities lose value. Banks had been required to set aside money from earnings to cover such declines. Under the new rules, banks are not required to set aside money against the portion of a loss judged to be temporary.

Companies were allowed to adopt the rule in the first quarter and required to adopt it in the second quarter. A study by Ciesielski found that 45 financial firms took advantage of the new rules in the first quarter to report higher earnings. He estimated that the total benefit exceeded $3 billion.

Bank of New York Mellon reported the largest benefit, more than $838 million, a key factor in its quarterly profit of $369 million. A spokesman said that the new rules better reflected the true value of the bank's holdings.

Impact Yet Unclear

The impact on second-quarter earnings remains unclear. While banks have reported their bottom-line profits and provided investors with some details, they have several weeks to file more detailed disclosures. Wells Fargo already has reported a second-quarter benefit of about $664 million.

The new proposal actually applies the same idea to long-term investments, but with dramatically different consequences.

Banks already were required to report fair values for short-term investments. The change this spring made doing so less expensive. But while the new fair value rules are less onerous than the old ones, neither set applies to long-term investments, which make up the vast majority of bank assets.

Even as market prices plunged during the financial crisis, banks reported that most long-term investments had held their value. By requiring banks to report fair values for their entire portfolios, the change could force many banks to acknowledge steep drops in value.

As with short-term investments, most of those declines would not reduce earnings directly. But banks could be required to set aside money from capital, or their reserve against unexpected losses, to cover the predicted losses. That could leave many banks with less capital than regulators require, forcing them to raise money.

The board's staff recommended the proposal at a mid-July meeting. The board could issue the proposal for comments after its August meeting, a spokesman said.

The industry is preparing to fight the rule change aggressively. Many bankers blame existing mark-to-market accounting rules for deepening the financial crisis, by creating a cycle in which desperation sales dragged down market prices, forcing additional fire sales and further declines in asset prices.

Banks already must acknowledge losses if a borrower stops making payments. But opponents of mark-to-market accounting question why a bank should be required to report the fluctuating value of a loan it intends to keep if the checks keep coming every month.

"It's hard to believe this is the direction they're taking," said Donna Fisher, tax and accounting director for the American Bankers Association. "The current environment has demonstrated the flaws in market-value accounting."

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