Opening the Books

By Kenneth Cline

Amid a regulatory crackdown on financial reporting and corporate governance, institutions need to exude conservatism and transparency.

The world of corporate governance and financial reporting changed dramatically in the wake of the Enron Corp. scandal, for banks as well as for all other U.S. companies.

One can debate how much of a change occurred in the actual rules, a situation complicated by the fact that many of the new regulations have been proposed but not yet implemented. But there's unquestionably been a profound shift in the "atmospherics," the political and business environment in which corporate activities are scrutinized by the regulatory authorities and public at large.

For banks, that means the regulators "are more zealous in trying to root out error, or what they perceive as error," says attorney H. Rodgin Cohen. "They're less willing to enter into a dialogue with bankers as to what is right and what is wrong."

Since the implosion of the Houston-based energy giant and some other scandal-racked companies, such as WorldCom Inc. and Tyco International, U.S. corporations are being held to much higher standards of accountability. Company executives must personally certify the accuracy of annual earnings, while directors and auditors are given more responsibility and independence from management. And the pressure is coming from all directions, including the Sarbanes-Oxley Act of 2002 and recent and proposed directives from the Securities and Exchange Commission, New York Stock Exchange and Financial Accounting Standards Board.

None of the new rules are specific to financial institutions. But since banks are already heavily regulated, they have probably felt the political and regulatory heat more intensely than non-banks. New York City-based giants Citigroup Inc. and J.P. Morgan Chase & Co., for example, are being investigated for their financial relationships with Enron and other troubled companies. PNC Financial Services Group of Pittsburgh was put through a regulatory-mandated management shakeup and had to restate 2001 earnings because of objections to certain off-balance sheet transactions.

Even companies normally considered paragons of operational solidity have run afoul of the regulators. Last November, widely-admired Fifth Third Bancorp of Cincinnati was slapped with an acquisitions moratorium because of accounting errors in its bond portfolio.

So how should bankers respond to all this heightened scrutiny and regulatory enforcement? For answers to that question, Banking Strategies convened a discussion group composed of Mr. Cohen, the chairman of Sullivan & Cromwell, and two other authorities on corporate governance and financial accounting: Robert Kelly, chief financial officer, Wachovia Corp., Charlotte; and Eugene O'Kelly, chairman and chief executive officer of KPMG LLP, New York.

The three, interviewed at BAI's Treasury, ALM and Risk Management conference in New York City last October, agreed that institutions need to recognize the new realities and take the most conservative approach possible, which includes making their financial reports and corporate governance structures fully transparent. As Mr. O'Kelly put it, "There's not a lot of tolerance in the system right now."

Banking Strategies: What's the situation facing banks in the wake of corporate scandals such as those afflicting Enron and WorldCom?

Cohen: At this point, it's more a matter of atmosphere. It's an atmosphere in which the regulators — the Securities and Exchange Commission and the banking agencies — are more zealous in trying to root out error, or what they perceive to be error. They're less willing to enter into a dialogue with bankers as to what is right and what is wrong.

The consequence has been a more defensive and conservative approach by most banks, along with harsher penalties if an agency believes a bank has acted inappropriately.

O'Kelly: The old rules don't apply and the new rules have yet to be written.

Banking Strategies: How would you characterize the new rules?

Cohen: I'd say most of the new rules that have actually been adopted by the SEC deal more with process than content. For example, you have to file your quarterly and annual earnings statements more rapidly. You've got to have the financial statements certified. And you've got to demonstrate an internal control procedure. But there's really been relatively little guidance as to the content of what must be disclosed.

Kelly: The most notable thing to us has been the process we've had to build around certification. We're now setting up an internal disclosure committee to make sure we're touching every potentially important topic.

The relationship we've had with our auditors is also going to change because of Sarbanes-Oxley. We'll have to decide which non-audit services the auditors can provide. And for the first time, our directors on the audit committee have to get involved in the approvals of those services. Sarbanes-Oxley puts a lot more onus on directors, no question about it.

Banking Strategies: What other features of Sarbanes-Oxley affect the banking industry?

Cohen: One that has caused significant difficulty for banks is Section 402, which precludes loans to executive officers and directors. This came in at the last minute. Nobody had time to think about what the phrase "loans and extensions of credit" meant. The consequence was that all sorts of arrangements with executives, that had been around for years and were never questioned, are now under scrutiny.

But clearly, the most important provisions involved certification. And then there was the whole relationship between the accountants and the companies they provide services to, as well as the oversight of the accounting profession in general.

O'Kelly: Before Sarbanes-Oxley, we accountants worked principally for the client company's chief financial officer. Now we work with the CFO but for the audit committee. Sarbanes-Oxley made that very clear. Also, our profession goes from one that was self-policing to one that has governmental oversight.

Cohen: This illustrates the old adage, "Legislate in haste and repent at leisure." I don't think comprehensive thought was given in Sarbanes-Oxley as to what triggers an auditor being disqualified to provide non-audit services, for example. How would that affect joint ventures?

Another major problem involves the requirement that a so-called "financial expert" be on every audit committee. I suspect that very few companies have a single director who qualifies. Most of the members of the new accounting oversight board, in fact, would not qualify.

Banking Strategies: So the major impact of Sarbanes-Oxley on the banking industry has been in the area of auditing?

O'Kelly: No. The main impact is on corporate governance, including the steps that lead up to the earnings certification process.

Now, the banks do have a head start there because of the Federal Deposit Insurance Corp. Improvement Act of 1991, which required bank management teams to provide an annual report on controls over financial reporting. As a consequence, banks don't have to close the gap as dramatically as do some manufacturing companies, for example, since they already have an existing process that helps to support the new certification requirement.

Banks do, however, face a major change regarding the involvement of the board in the certification of the SEC filings. It's a much more complex process now.

Banking Strategies: Will institutions be burdened with a lot of additional work as they comply with these requirements?

O'Kelly: The SEC has called for expanded disclosure. It wants to improve the transparency of financial reporting in the areas of liquidity and capital resources, including off-balance sheet arrangements; certain trading activities; and relationships and transactions on terms that would not be available from clearly independent third parties.

This move, coupled with the SEC staff's desire for more and better disclosure of critical accounting policies, probably will increase the volume of financial data in annual reports by as much as 25% to 30%.

Kelly: The workload for directors and audit committee members is increased even more so than for management.

I would expect that the audit committee of every public company in the nation is more demanding than it was, say, a year ago. And rightfully so. The audit committee needs to know more about the risks facing the company. We're spending more time in meetings. That's not necessarily a bad thing. It's great that directors are taking more time to understand the risks and exposures facing the company.

Banking Strategies: Speaking of risks, what's the situation of the banking industry now in regard to special purpose entities, or off-balance sheet structures?

O'Kelly: Banks are generally significant users of SPEs, both for their own benefit as well as for their customers. So they are affected by any changes here.

The FASB will soon issue an interpretation of which types of SPEs should remain off-balance sheet and which should be consolidated by the sponsor or the primary beneficiary of the arrangement. It is anticipated that the new requirements will result in more SPEs being consolidated.

So the major change will involve one of two things — either the business won't get done, or it will have to be consolidated, likely by bank customers. Hence, it's conceivable that going forward, the use of SPEs will be less widespread.

Banking Strategies: Will banks themselves have more difficulty shifting risks off their balance sheets? Regulators forced PNC, for example, to take back, or consolidate, $550 million in bad loans last January.

Cohen: The impact will be limited as long as qualified SPEs aren't affected by the changes. I think the last thing anybody should want to do is to require consolidation of credit card- and mortgage-backed vehicles. That would not only increase the cost of capital, but would also certainly reduce the availability of credit to consumers.

O'Kelly: There are several thousand SPEs sponsored by banks collectively. A good number of those could be affected by this change in the rules. Therefore, it's going to have a dramatic effect on what has been a very deep market for this type of structure.

Kelly: The controversy over SPEs last winter reminded me of the derivatives controversy in the early- to mid-'90s. Everyone thought all this off-balance sheet stuff carried a lot of risk and was going to lead to big problems for the industry.

I think regulators are now realizing that, by and large, companies have done a good job of accounting properly for SPEs. Even so, the new FASB rules may require that some of these SPEs have to go back on the balance sheet eventually, which may require some banks to deploy a little more capital against them.

We're very comfortable with that prospect at Wachovia. On a Tier One capital basis, it would have a very minor impact on us, maybe 10 basis points. The more worrisome thing will be the added cost to customers. If these financing vehicles do come on-balance-sheet, I suspect that pricing for customers will have to be increased because of the greater usage of bank capital. So one possible result is that U.S. corporations will find it more expensive to raise capital.

Banking Strategies: So the major impact of the SPE controversy will be on bank customers rather than the banks themselves?

Kelly: Ultimately, yes. But in the short term, there will be a lot of gnashing of teeth regarding how we're actually going to account for the SPEs, on- or off-balance sheet, and what the new rules will require. Hopefully all that will be resolved sometime this year. The ultimate impact, which remains to be seen, will be on the cost and availability of capital.

Banking Strategies: Did the regulators over-react in the PNC situation?

Cohen: PNC was unfortunate enough to be in the wrong place at the wrong time. Had that incident happened a year earlier, the regulatory reaction might not have been as severe.

As I said at the beginning, the regulatory atmosphere has changed. There is a tendency on the part of the regulators to interpret errors as malfeasance. Business people make a lot of judgement calls, and they're not always right. But that doesn't mean they acted in bad faith.

O'Kelly: Accounting is not a science; it's an art. And there are many ways to interpret numbers. I do worry about the tone as well, because I suspect that the number of companies that actually participated in fraudulent activities was pretty small.

There is a debate over whether we should go to a "principle-based" accounting model versus the current rules-based model. The critics of the rules-based model always cite the fact that it takes FASB four years to write something Wall Street can circumvent in 40 minutes.

What gets lost in that debate is the highly regulated and litigious nature of our society. Corporations need to have some basis on which to justify the judgments they've made. Rules are perceived to provide a degree of safe harbor to them.

Kelly: I have a slightly different take on that. I worry that companies focus too much on rules and don't adequately consider the fundamentals of what they're reflecting in their financial statements. They should be asking, "Are we doing the right thing?" instead of, "Did we follow the rules perfectly?" I suspect some U.S. companies got into trouble because they focused too much on the rules and how to get around them.

Cohen: I don't think rules and principles are mutually exclusive. Certainly principles should infuse the rules, because you're never going to have rules that eliminate some element of judgment.

I would be the last to minimize the concerns about litigation. In fact, I believe that's a hidden tax paid by corporations in this country. But litigation does tend to follow the money, not rules or principles. And if a stock drops a lot there's going to be litigation, because that's when the plaintiff lawyers see opportunity.

Kelly: I'm certainly more focused on litigation dangers today than I was five years ago.

Cohen: One area of litigation, which is Enron-related and has received little attention, is the phenomenon of financial institutions suing each other for the losses they have incurred. That, in my view, is usually extremely shortsighted.

I'm sure somebody could cook up a legal theory, for example, where all the parties involved with Enron could sue each other. This poses an enormous cost to companies. And who knows what a jury somewhere will do? If that spins out of control, it could be a real problem.

Kelly: Recently we were doing a fairly basic transaction with another financial institution, and they asked us to sign a statement saying they had nothing to do with the accounting for the transaction. I can see a mini-industry being created here, where CFOs are constantly signing statements for each other. I don't think that makes any sense.

Banking Strategies: Is the willingness of banks to cooperate with each other deteriorating a bit in this new environment?

Kelly: I wouldn't say "deteriorating." I would say banks are more defensive and nervous. It goes back to Gene's comment that we don't know what the rules are.

Banking Strategies: One area that has definitely changed for banks — and all U.S. corporations — is the way earnings are reported. How is the regulatory environment different, post-Enron?

Cohen: That's an issue that actually precedes Enron with the SEC's Regulation FD, which prohibits selective disclosure of material financial information that can affect a stock's price. But post-Enron, companies do have an enormous reluctance to provide guidance. And the consequence of that is — surprise — volatility.

O'Kelly: When Arthur Levitt was chairman of the SEC in the '90s, the agency moved to curb what it defined as "earnings management," but what others viewed as balance sheet "conservatism." The result was the reporting of a greater level of volatility in earnings. Additionally, the SEC issued new rules for companies to follow in determining what is "material" to investors.

Today, banks and everyone else have to evaluate every decision they make in terms of its materiality from a disclosure and earnings standpoint, both quantitatively and qualitatively. For example, AOL Time Warner recently restated its quarterly results for an amount that seems immaterial from a quantitative standpoint, but presumably was deemed material by the company from a qualitative perspective.

This whole process has put the disclosure world in flux.

Kelly: That raises an interesting point. We speak to our directors now not only about earnings risk, but also about market capitalization risk. A certain strategy may cost x million dollars to execute, but the real cost has to include what it does to your stock price and cost of raising capital. Reputational risk issues are almost more important now than financial issues in terms of valuing your stock.

On a related topic, I'm worried about the whole culture of consensus estimates. Some companies may do whatever it takes to meet that number. That's a very unhealthy thing for the capital markets. I've been advocating publishing a range rather than a single number, but I don't see that happening in the short term.

Cohen: One of the problems I have with the new environment is that many of the corporate governance and disclosure rules have evolved from what I call a "manufacturing-centric model." The special issues for banks were not addressed.

It's one thing, for example, to accelerate the time period for producing periodic financial reports if you are a relatively simple manufacturer. It's another thing for a bank whose quarterly reports may be twice as long. It's not so easy to get it done.

Another example is the SEC's most recent proposals relating to the quantification of changes in underlying assumptions for critical accounting policies. The most important critical accounting policy for any bank is the provision for loan-loss reserves. How can you possibly apply the quantification test to that? I find it intriguing that all the sample applications of the rule provided by the SEC apply to manufacturers.

Banking Strategies: Summing it all up, what sort of advice would you provide to bankers struggling to navigate their way through this new legal and regulatory environment?

O'Kelly: You have to strike the right balance between growth and risk management. And part of managing risk today is the corporate governance aspect, which is evolving as we speak. This is probably a period where you have to take a more conservative tack. There's not a lot of tolerance in the system right now.

Kelly: I agree that the key point is conservatism. Now is not the time to be challenging the world on some of the issues that we've discussed.

Another fundamental issue has to do with treating your shareholders and analysts as customers. The more transparent you can be, the simpler and easier you can disclose issues to help bring them into perspective, the better. Over time, the market will reward you for better transparency and clarity.

Cohen: I agree the two keys are conservatism and transparency. In today's world, that's what is needed.

Mr. Cline is senior editor of Banking Strategies.

Copyright © 2003 by Banking Strategies, published by BAI.

back to top