Marking bank loans to market

By Felix Salmon
May 28, 2010
FASB's proposed rule change, which Tracy Alloway calls "mark-to-mayhem".

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Should banks mark their loans to market? The issue — which flared up briefly at the height of the financial crisis, when everybody was wondering whether many of America’s largest banks were insolvent — is back in the headlines, thanks to FASB’s proposed rule change, which Tracy Alloway calls “mark-to-mayhem”.

Cue the predictable response from the American Bankers’ Association:

If implemented, the proposal would greatly undermine the availability of credit by making it difficult to make many long-term loans, the value of which, even if performing perfectly, would likely be reduced on the day a loan is made.

As a curio, before the financial crisis, banks’ fair value numbers were generally above book value. At that point no one really seemed to care about the discrepency, or mark-to-market, for that matter.

It’s not obvious just how much mayhem the proposed rule change would cause, since Businessweek’s Michael Moore says that “changes in the fair value of loans probably wouldn’t show up in banks’ earnings”. But I’m not completely convinced that this is a good idea.

In general, I’m all in favor of transparency in the reports of public companies in general, and banks in particular. So if banks are forced to reveal the true value of their assets, that’s good. But it’s not good if it just results in effective bank runs, where banks with low-value loans found themselves shut out of the repo markets, for example.

It’s certainly true that when any individual bank — like Goldman Sachs, for example — starts marking its assets to market, that imposes a very useful discipline and can help that bank avoid large losses: when the loans start dropping in value, they get dumped sharpish.

But that’s much easier for Goldman Sachs than it is for commercial banks with enormous long-term loan books and valued relationships with their borrowers. What’s more, it would be disastrous if every bank in America started dumping its loans every time they fell in value — given that they would all be sellers rather than buyers, the value of the loans would plunge enormously overnight, and then they really would all be insolvent.

My feeling is that so long this is just an extra reporting requirement, and it doesn’t show up on the income statement or the balance sheet, we’re probably fine. Banks should certainly be marking their loans to market internally, and if they’re doing that it makes sense to ask them to report those marks to their shareholders on a quarterly basis. But there is a real risk here, if those shareholders start to panic when they see the marks.

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