FASB Urged to Strengthen Disclosure Rules for Banks’ Credit Risk Transfers
September 4, 2024
A former senior U.S. bank supervisor has sounded the alarm on the lack of transparency in U.S. banks’ reporting of credit risk transfer (CRT) transactions, citing significant concerns over the accuracy of regulatory capitalization ratios.
Jill Cetina, currently an Executive Professor of Finance at Texas A&M University, has urged the FASB to ensure that CRT transactions are fully reflected in U.S. banks’ financial statements under U.S. Generally Accepted Accounting Principles (GAAP). In a recent letter to the board, Cetina emphasized that the current regulatory framework does not require banks to disclose CRT transactions or their impact on regulatory capital ratios, creating substantial data gaps.
“U.S. GAAP offers limited visibility into banks’ use of CRTs,” she wrote.
CRT Transactions Lack Transparency
Some U.S. banks are using CRTs to strengthen their regulatory capital ratios, which have been weakened by interest rate changes. However, these transactions are not truly reducing risk, but rather masking it, Cetina argued. For example, banks may use CRTs to transfer credit risk to other parties, but this does not necessarily mean that the risk has been eliminated. Instead, the banks may still be exposed to significant losses if the transferred risk materializes.
To make CRT transactions more transparent, Cetina has proposed several measures. First, she suggests that the FASB require banks to fully disclose CRT transactions in their financial statements, including the impact on regulatory capital ratios. Second, she recommends that bank management make representations and warranties about significant risk transfer when reporting their Common Equity Tier 1 (CET1) ratio, a key metric that measures a bank’s core equity capital compared to its risk-weighted assets (RWA). Finally, she proposes that the FASB review recent U.S. bank CRT transactions and associated financial reporting to ensure full reflection in financial statements.
“Investors should be able to discern the impact of CRT transactions on a U.S. bank’s reported risk-based regulatory capital ratios, its liabilities, its cash position, its allowance for credit loss (ACL), and earnings,” said Cetina, who also held a prior role as senior manager for the U.S. bank rating team at a major bond rating agency.
U,S. banks that have utilized CRTs include: JP Morgan, Morgan Stanley, Santander, US Bancorp, and Western Alliance. “Some banks do provide some disclosure in their US GAAP filings information related to their use of CRTs, others do not,” Cetina explained.
Not Everyone Agrees on CRT Reform
The letter noted that the lack of transparency is particularly concerning given the lessons from the 2008 financial crisis, when CRTs engineered with credit default swaps (CDS) went awry, transforming credit risk into counterparty risk and ultimately systemic risk. This alludes to a broader theme but not everyone agrees on the issues at hand.
Specifically, a counterargument is that CRTs are a legitimate risk-management tool, and any additional transparency disclosures should be governed by global banking standards, not U.S. accounting rules.
“The use of CRTs as a whole is a risk-mitigating strategy by a bank to reduce the potential valuation issues surrounding RWAs,” said Alex Eng, vice president of U.S. Corporate Financial at EDF Renewables, on August 29, 2024. “Sure, there are other financial reporting issues, but these aren’t necessarily realized nor are they currently under U.S. GAAP,” he said by email.
Eng, also general counsel and chief legal officer of the Institute of Management Accountants (IMA), suggested that any disclosures for commercial transparency regarding the use of CRTs should come from the Basel Committee on Banking Supervision (BCBS) through Basel III+ rules (a set of global regulatory standards for banking), “and not the U.S.-based FASB.”
[Thomson Reuters]
