Disclosure Standoff

By John W. Milligan

Banks shy away from disclosing too much financial information, but investor pressure and recent accounting scandals may force greater openness.

A large company sees its stock dive when news breaks that it has been using complex derivative instruments to prop up earnings. Public disclosures aimed at calming the market only fuel more selling. "Investors hear the word 'derivatives' and think we must be rolling the dice, shooting up, and taking big risks," fumes the company's chief investment officer.

Another company beset by investor skepticism in the wake of the Enron Corp. scandal? No, the year was 1994 and the company was Columbus, Ohio-based Banc One Corp. (now part of Bank One Corp., Chicago). Executives tried to quickly explain away their use of derivatives as a legitimate means of hedging interest rate risk. But Banc One's stock drifted downward for the next several months, bottoming out only after the bank took a special charge of $170 million to restructure its investment portfolio.

Today, bank investors are worried again about derivatives and the main issue, as before, is disclosure. Investors and analysts in 1994 felt blindsided when they learned that an institution primarily noted for prolific acquisitions and consumer banking had been making extensive use of such complex and risk-laden financial instruments. Likewise today, they worry that "familiar" banks aren't fully disclosing their exposure to derivatives, proprietary trading, hedging and interest-rate shifts in general.

Although banks do provide analysts and investors with more information about their derivatives activities than was the custom in 1994, the usefulness of that data remains in dispute. "It tells us a lot and nothing at the same time," says veteran analyst Nancy Bush, formerly with Ryan, Beck & Co. in Livingston, N.J.

Today's concern is heightened by the series of accounting scandals that began with Enron in 2001 and since has spread far and wide across corporate America. While derivatives were only peripherally involved in the Enron situation, investors have awakened to the fact that the total notional value of derivatives held by commercial banks in the United States reached $46 trillion in the first quarter of 2002, up from $17 trillion in early 1994. The seven largest institutions accounted for 96% of this total, led by J.P. Morgan Chase & Co.

It's probably unfair to say that this is a disaster waiting to happen. Yet, it's hard to tell the full extent of risks based on publicly disclosed information, which heightens investor anxiety. While banks have legitimate business reasons for not revealing all the details of their trading and hedging activities, experts say disclosure policies have not advanced much beyond the early '90s. At the same time, the market — and concomitant risk — has grown much larger.

In the wake of Enron and related scandals, financial institutions will likely come under pressure to tell more. Already, PNC Financial Services Group and Morgan Chase have become entangled in the Enron-related controversy over "special purpose entities," those off-balance sheet mechanisms that sometimes include a derivatives component.

In such an environment, the case for proactive disclosure is strong. Greater transparency will result in greater investor confidence, which can only help bank stock trading valuations in the long run. And the risk of not being proactive is significant — the regulators, after all, are waiting in the wings. "If important matters are not clear, you, in effect, have misled," says John W. Spiegel, chief financial officer for SunTrust Banks Inc. in Atlanta.

Hidden Risk

A derivative is a financial contract whose value is derived from changes in the performance of underlying assets, interest rates, currency exchange rates or indexes. If used correctly, derivatives can protect an institution against sudden shifts in interest rates or other economic phenomena. But since they can magnify the effect of underlying market changes, they can also magnify risk when used for speculative purposes. At their most esoteric, derivatives are highly complex instruments that tax the comprehension of many top bank executives, let alone outsiders.

Over the past decade, derivatives have become a more accepted part of the financial services landscape, providing an important line of business for large trading banks such as Morgan Chase, Citigroup Inc. and Bank of America Corp. Derivatives trading revenue for the industry reached $2.68 billion in 2001, according to the Office of the Comptroller of the Currency. Like the old Banc One, many more banks use derivatives to offset their exposure to changes in interest rates.

Since 1990, when the OCC first began to track the rise in total notional value of derivatives that are held by all U.S. banks, volume has grown by more than 450%. Notional value refers to the face amount of the securities underlying a derivative contract, rather than the amount that actually changes hands between two parties in a trade. The notional total stood at $46 trillion at March 31, 2002.

The steady rise in notional volume, which has accelerated since 1998, might have caused nary a ripple with analysts and investors were it not for the accounting scandal that engulfed Enron, the Houston-based energy company. At the heart of the Enron debacle was a series of complex, off-balance sheet partnerships that produced a distorted picture of the firm's profitability. And many of those partnerships allegedly used derivatives to profit insiders at the parent company's expense.

But the Enron debacle was more about disclosure than derivatives per se because the firm's senior managers withheld knowledge of the partnerships from investors. And in the new atmosphere of investor skepticism that gripped the market once the enormity of Enron's deceit became apparent, it was only logical that the banking industry's disclosure practices would come under the microscope as well.

The first sign of this came in January when PNC was forced to restate its 2001 earnings under pressure from the Federal Reserve. The issue involved a "special purpose entity," or SPE, that PNC used to transfer $550 million in troubled loans from its own balance sheet to an investor group.

While other banks have used SPEs for the same purpose in recent years, SPEs had just attained notoriety for their prominent role in the Enron debacle. When looking at the PNC transaction, regulators apparently decided that the company had retained too much residual exposure to the problem credits. They forced it to reinstate the loans on its balance sheet and recognize a $155 million charge in 2001's fourth quarter.

The episode suddenly pushed the disclosure issue to the forefront of investor concerns. PNC had not previously reported its use of the SPE to investors. By taking back the bad loans and recognizing the charge, PNC acknowledged under duress that it had not alerted investors to a material risk facing the bank. Analysts worried that other banks might harbor similar hidden risk, contributing to a 5% drop in the bank stock index in the immediate aftermath of PNC's earnings revision.

Real-World Disclosure

It must be said that Wall Street has an insatiable appetite for disclosure that no bank can satisfy completely. "Being an analyst, I'm always going to ask for more," says Adam Compton, who covers banks for Keefe Bruyette & Woods Inc., New York City.

For their part, bankers point to the mountains of information they already distribute into the public realm. First, there are the quarterly and annual financial statements that public companies are required to file with the Securities and Exchange Commission. These are then supplemented by quarterly earnings conference calls and the special presentations that companies make periodically, typically at brokerage-run conferences.

Even so, analysts have been griping for years about inadequate disclosure from financial institutions in such areas as the loan portfolio and interest rate risk. Hal Schroeder, a portfolio manager at Dallas-based hedge fund Carlson Capital LP, would like to know how far out on the risk curve banks venture when making loans, so that publicly reported data can be used to predict the likely performance of those loans when the economy softens. "It's not enough to say you grew loans by 10%," Schroeder says. "I'd like to know, for example, if 25% of that growth was investment grade and 75% was non-investment grade."

Schroeder also dislikes the way most banks discuss their interest rate exposure in their annual reports and 10K regulatory filings. Often, they will project the effect of a parallel shift in interest rates on their net interest income — with both ends of the yield curve changing up or down by the same magnitude. Unfortunately, this analysis fails to approximate how interest rates frequently behave. "I'd like to see more real-world disclosure," Schroeder says.

When it comes to derivatives specifically, the current disclosure practices of major banks leave analysts dissatisfied on a number of fronts. The primary driver behind these disclosures is Financial Accounting Statement 133, which took effect in January 2001. It requires that all derivative instruments be recorded on an institution's balance sheet at their fair market value. But there are other important aspects of a bank's derivatives exposure that don't have to be disclosed under FAS 133, leaving an incomplete picture at best. "Accounting changes haven't added clarity to what's going on," says Keefe Bruyette analyst Thomas D. McCandless.

Banks, meanwhile, worry that disclosing too much information might reveal sensitive information — for example, the trading positions they have taken on their own account. This could place them at a competitive disadvantage to many foreign banks. "A lot of it has to do with proprietary risk-taking," says analyst Michael Mayo at Prudential Securities in New York. "The big U.S. banks don't want to give away too much information about their trading strategies, and whether the trades are made on behalf of clients or on their own account."

It is also within the basic nature of most banks to disclose information cautiously when entering into a new area, particularly one as difficult to understand as derivatives. As Schroeder quips, "No one wants to be on the bleeding edge of disclosure."

SunTrust's Spiegel attributes this reticence partly to the fact that accounting and financial officers at banks are hampered by their relative inexperience with derivatives disclosure in general. Unlike data on credit quality, which banks have been disclosing for decades, "You don't have 20 years or so of experience with a form of presentation on derivatives," Spiegel says. He adds that it is common practice for bankers to send each other copies of their annual reports, which implies that they do pay close attention to how much information other banks disclose.

Economic Risk

The upshot of all this tension between Wall Street and public companies, combined with the limitations of FAS 133, is that an outsider looking at bank annual reports typically still struggles to glean useful information about interest rate or trading risk. And what information is available would not be comparable from bank to bank.

In its 2001 annual report, Morgan Chase disclosed $24 trillion in notional principal outstanding at yearend 2001, but reported its credit exposure was just $51 billion after legally enforceable netting agreements and collateral were taken into consideration. The latter figure is a closer approximation of its economic risk from derivatives. Morgan Chase deserves some credit for using investor presentations to provide greater insight into its derivatives activities, particularly its approach to managing the risks of such a large portfolio. But analysts say the bank still avoided making any disclosure that would permit investors to make their own judgments about whether it was managing the business prudently.

Bank of America, according to the OCC, had $9.2 trillion in notional principal outstanding at the end of last year. The Charlotte-based bank elaborated on that in its 2001 annual report with a chart breaking out its $22.1 billion in net credit risk by product category. It also provided yearend 2000 data for comparison purposes.

Citigroup, meanwhile, provided only scant information about its derivatives activities, despite having the third-largest total of notional outstandings last year, nearly $6.5 trillion, according to the OCC. Buried in Citi's extensive annual report is a disclosure that its credit exposure from derivatives and foreign exchange contracts totaled $29.8 billion in 2001, although it did not provide a breakdown between derivatives and foreign exchange activities.

Elsewhere in the report, Citi revealed that it garnered slightly more than $4 billion in revenue last year from trading fixed income instruments, including a variety of derivative contracts, as well as government, agency, municipal and corporate securities. Again, it did not provide a detailed breakdown between the various categories.

(Morgan Chase, BankAmerica and Citi declined to make a senior financial executive available to be interviewed for this story.)

It's likewise all but impossible to determine the effectiveness of a bank's hedging program based on the disclosures required by FAS 133. According to the standard, when a hedge does not correlate with its underlying security at least 85% of the time, it must be marked to market and the gain or loss recognized in the income statement. Wells Fargo & Co., which uses derivatives to offset its large portfolio of interest-sensitive mortgage servicing rights, reported a $521 million net gain last year for its so-called ineffective hedges.

But this doesn't mean Wells Fargo's hedging program was flawed; only that it had a large number of hedges that for some reason didn't correlate with at least 85% effectiveness. Unfortunately, the bank did not explain why its ineffective hedges totaled so much. Wells Fargo comptroller Les L. Quock admits it's very difficult to assess the overall effectiveness of the bank's hedging program from its yearend report. "It's hard to pull that out of the disclosure," he says. "The report has a lot of big numbers in it."

Is it really in the banking industry's interest to leave the investment community in the dark about such an important issue? "If the reader doesn't understand the information being disclosed, then the disclosure is ineffective," says Gregory H. Kozich, a partner at the PricewaterhouseCoopers.

Kozich argues that companies stand to gain from greater transparency if it results in greater investor confidence. The firm recently issued a lengthy treatise arguing in favor of complete transparency in corporate reporting. "Whatever information management uses to run the company should be the basis of what it reports to the marketplace," the report states. "This philosophy stands in stark contrast to the prevailing practice where most companies report only what regulation requires and then report more only as compelled to do so."

Such statements do not constitute a blanket indictment of bank disclosure practices. But they do highlight the new level of tension surrounding this issue. When it comes to derivatives and how they're being used by the large commercial banks, investors "are not going to give the banks the benefit of the doubt," says analyst Mayo.

Mr. Milligan is a freelance writer based in Charlottesville, Va.

Copyright © 2003 by Banking Strategies, published by BAI.

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