New bank mark-to-model data is no measure of risk

By Jane Baird - Analysis

LONDON (Reuters) - A new U.S. accounting rule requiring banks to give detailed data on assets valued purely by mathematical models sheds light on the quality of their numbers, but has little value in assessing their risk exposure.

Figures required by rule FASB 157 have generated keen interest among investors anxious to assess the reliability of bank reporting and ascertain exposure to losses on U.S. subprime mortgage-backed securities and other instruments shunned by the market since the credit crisis began.

Under the new rule, a bank must include a table in its quarterly reports that breaks down its assets and liabilities into three categories.

Level 1 includes everything with a market price. Level 2 tallies assets whose values are modeled but have the benefit of market-based inputs such as interest rates or credit spreads. Level 3, the most open to interpretation, are assets valued by model alone, using assumptions and extrapolations rather than market inputs.

"The Level 3 total figures don't give you a clear indication of the degree of risk," said a partner and bank auditor at one of the big four accounting firms who did not want to be named. "It is not a risk measure."

Many complex credit products such as collateralized debt obligations (CDOs) were designed for holding to maturity and have little or no secondary market. Before the crisis, banks could value many of them by citing prices of new CDOs coming to market -- Level 2 methodology.

Now, in the absence of new deals since the bottom has fallen out of the structured finance market, many of these securities have dropped into Level 3.

OFF THE HOOK

In the United States, FASB 157 officially kicks in for 2008 results, but major U.S. banks have already adopted it this year.

European banks registered with the U.S. Securities and Exchange Commission, such as Royal Bank of Scotland (RBS.L) and Deutsche Bank (DBKGn.DE), were given a reprieve last week from providing FASB 157 numbers in their SEC filings next year.

The SEC voted that foreign companies no longer have to reconcile their accounts to Generally Accepted Accounting Principles (GAAP) if they use International Financial Accounting Standards (IFRS) set by the International Accounting Standards Board (IASB).

The IASB has issued a discussion paper drafted from FASB 157, the first step toward adopting it under IFRS. It could become a rule in 2009 at the earliest, an IASB spokesman said.

Before the new SEC vote, a few European banks were already ahead of the requirement. HSBC (HSBA.L) began giving a table citing amounts under Levels 1, 2 and 3 this year, while UBS (UBSN.VX) has provided numbers on exposure to top tranches of CDOs that it said were based on Level 3 methodology.

USE WITH CAUTION

Journalists and analysts have begun citing banks' Level 3 assets and comparing them with total assets, but accountants caution against reading too much into the FASB 157 figures.