Beyond mark to market

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An additional measure was taken a few months ago that just struck me one of the possible reasons for the current economic setback.

This is best illustrated first by an example.

My (very small) bank holds securities in its ‘hold to maturity’ account.

If these securities become ‘impaired,’ as defined by regulation, they are marked to market and capital adjusted for that loss.

But recently an additional measure was taken by the regulators.

If they are downgraded to below ‘investment grade’ they are not only marked to market for net capital calculations,

but also treated as a ‘charge off’ for capital ratio purposes.

For example, if we have $1 million security that is downgraded below investment grade and has a current market value of $500,000,
we reduce our stated capital by $500,000, as had previously been the case.

But now, even that $500,000 remaining value, is, for all practical purposes, counted as 0 for purposes of determining our capital ratios.

The capital ratio is the important calculation as it determines how many assets a bank can carry for a given level of capital.

This means, for example, that if a bank had securities that were below investment grade with a market value equal to all its capital
it could not carry any other assets or deposits.

They call this ‘super risk weighting’ or something like that. More details to follow, and any additional info welcome, thanks!

Meanwhile, this has resulted in a sudden drop in the all important capital ratios,
and with every downgrade below investment grade by the ratings agencies, a much larger capital reduction takes place than under previous rules.

And, equally important, all banks holding any securities are at risk of losing all ‘credit’ for even the fair market value of their securities
for purposes of determining their capital ratio compliance.

Additionally, this can force sales of these securities as the proceeds of a sale at least add that much capital back to the capital ratio determination.

And the forced sales, of course, drive prices down below even today’s depressed market values.

This provides high yielding securities with little or no risk at the now lower prices for unleveraged buyers, at the expense of the banking sector.

Banks are public private partnerships, and it looks like the public partner is shooting itself in the gut contrary to any notion of public purpose.

Regulators have told is there is no chance for this rule to be altered.

And as an aside, we have a security that was simultaneously downgraded by one ratings agency and upgraded by another. Interesting how after all the criticism of
ratings agencies our govt has increased its reliance on them for purposes of public policy.