Regulators’ Exposure of Accounting Loophole Helped Banks Hide Risk

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Not exactly shocking news but one of the mysteries of the financial crisis is how it came to be that banks ended up with risk they supposedly transferred to investors.

Sure, it’s well known that the assets banks removed from their balance sheets did not shift much risk to investors after all, thanks to liquidity guarantees they supplied to investors. But that even took former Citigroup vice chairman and Treasury secretary Robert Rubin by surprise, as Rubin said he didn’t know such guarantees existed until after the bank was forced to increase its capital reserves because it had to make good on them.

Now research that came out a year ago but was revised late last month helps clarify what went awry.

It turns out that a conflict between the Financial Accounting Standards Board and federal bank regulators was even more critical than I thought it was when I reported it in 2004. The conflict arose after FASB voted to require commercial banks to consolidate such vehicles after such financing arrangements caused energy trading firm Enron Corp. to fail.

I was aware that the regulators asked the FASB to delay the new accounting rule and that the board eventually provided an exemption for so-called “qualified” special purpose entities, which provided a loophole from consolidation so long as they vehicles weren’t actively managed.

But the full significance of that escaped me until I saw the research, which shows that securitization along the lines of Enron’s — guarantees that limited or even eliminated investor risk — exploded after bank regulators codified the exemption in their capital requirements. Indeed, the exemption essentially paved the way for banks to use more off-balance-sheet financing vehicles that masked their true risk.

How exactly? In late 2004, the Federal Reserve Board, Federal Deposit Insurance Corporation and the Office of Thrift Supervision decided that asset-backed commercial paper put into special purpose vehicles known as conduits would not have to be consolidated for purposes of calculating capital requirements. And the regulators decided that banks need only reserve against 10 percent of the amounts put into conduits even when they guaranteed that investors would be repaid if there were a run on the conduits. Previously, securitizations typically put investors on the hook for that risk.

The research, originally published in May 2009 but revised in late January and entitled “Securitization without Risk Transfer,” found that the amount of subprime assets securitized through such vehicles soared in the wake of the exemption, even though the liquidity guarantees extended to investors meant that little or no risk had been transferred to them.

“Regulation should either treat off-balance-sheet activities with recourse as on-balance sheet for capital requirement and accounting disclosure purposes, or, require that off-balance sheet activities do not have recourse to bank balance sheets,” the authors, Viral V. Acharya and Philipp Schnabl of New York University and Gustavo Suarez of the Federal Reserve, conclude. “The current treatment appears to be a recipe for disaster, from the standpoint of transparency as well as capital adequacy of the financial intermediation sector as a whole.”