Banks' own credit risk hampers financial results

Own credit risk - the concept of including the credit risk of an institution in the measurement of the liabilities it issues - had a significant impact on banks' profits in the first half of 2009, as credit default swap (CDS) spreads referencing banks' own debt narrowed.

HSBC - which reported $6.6 billion of fair-value gains due to own credit risk over 2008 - registered a fair-value loss of $2.5 billion for the first half of 2009, as CDSs referencing the bank tightened from 94 basis points to 75bp. CDSs on Barclays narrowed from 159bp to 136bp over the first half of the year, resulting in the UK bank sustaining fair-value losses on its own debt of £893 million, compared with fair-value gains of £1.7 billion in 2008.

Deutsche Bank recorded €176 million of fair-value losses on its own liabilities in the second quarter, as CDSs referencing the bank tightened from 135bp to 110bp. The bank previously registered fair-value gains attributable to own credit risk of €4.7 billion in 2008, as spreads referencing the bank widened from 46bp to 134bp.

JP Morgan's credit spreads tightening from 199bp to 105bp over the second quarter resulted in losses on the bank's own debt of $1.1 billion. In contrast, it recorded fair-value gains due to own credit risk of $2 billion in 2008, as CDSs referencing the bank pushed out from 50bp to 119bp.

Having recorded fair-value losses of $1.5 billion on its own debt in the first quarter of the year, Morgan Stanley registered further losses of $2.3 billion in the second quarter. The former investment bank enjoyed a profit of $5.6 billion on its own liabilities in 2008 due to its credit spreads ballooning from 98bp to 402bp over the course of the year.

The tightening of spreads referencing BNP Paribas reduced the bank's profits by €237 million in the second quarter, compared with fair-value gains from own credit risk of €57 million in the first quarter, and a gain of €734 million over 2008. Local rival Société Générale recorded a loss of €336 million as a result of fair-value changes in its own liabilities over the first half, having recorded fair-value gains of €441 million in 2008.

Credit Suisse saw fair-value losses of Sfr242 million ($225 million) due to own credit risk in the second quarter compared with fair-value gains of Sfr329 million in the first quarter of the year. In 2008, the Swiss bank recorded fair-value gains of Sfr4.7 billion on its own debt. UBS recorded fair-value losses on its own liabilities of Sfr1.2 billion in the second quarter compared with gains of Sfr651 million in the first quarter of the year, and profits of Sfr2 billion in 2008.

The International Accounting Standards Board (IASB) and the US Financial Accounting Standards Board's (FASB) inclusion of own credit risk in liability measurement has proved controversial over the years. Dramatic fluctuations in credit spreads referencing financial institutions over the past 12 months have brought this issue to the fore again, as banks registered substantial profits from fair-value changes in their own debt last year.

"People use fair value when offsetting liabilities against assets carried at fair value. The problem is your assets tend to be across a portfolio of credits, many of which will be non-banks, whereas your liabilities are only based on your own credit. So because credit spreads on banks widened far more than credit spreads on other entities, there was this disparity in the accounting," explained Pauline Wallace, partner at PricewaterhouseCoopers in London.

Critics argue it is misleading for a bank to report a gain on its liabilities as a direct result of its own creditworthiness deteriorating, particularly as the bank would not be able to realise this gain unless it managed to repurchase its debt at current market prices.

"The idea that a fall in your credit rating leads to some profit and loss gain is counter-intuitive. It's the wrong result and we need to change the current standard," said Paul Chisnall, an executive director at the British Bankers' Association in London.

Others argue that excluding own credit risk from liability measurement could produce unusual accounting results, and almost certainly bring about an accounting mismatch between assets and liabilities held at fair value. "Several bank chief executives have said including credit risk in liability measurement is the dumbest idea anybody ever came up with. However, we need to be sure they understand the implications of that. Do they hate it more than they hate the accounting mismatch?" asked Wayne Upton, director of international activities at the IASB in London.

The IASB released a discussion paper on June 18 entitled Credit risk in liability measurement to seek market comment on the current standard and potential alternatives. The FASB has reviewed the matter of credit risk in liability measurement, but has preliminarily decided not to alter its current standard.

See also: European banks report modest Q2, despite increased provisioning