10 Ways A Bank Can Attempt to Hide Problem Assets

A previous article discussed bail-ins and how once a failing bank enters the bail-in process, the implications could lead to reduced access to customer deposits, a reduction in the availability of credit, and a loss of confidence in the banking system.

?Another article discussed how the Texas Ratio can be used to predict bank failures and how the ratio can be used to compare the health of different banks.

?Banks are vitally important to the economy – serving as a cornerstone of the financial system. The numerous banks that failed during the 2008 financial crisis had far-reaching tentacles that adversely affected employment, asset prices, and consumer confidence, to name just a few.

?One would think that it is in everyone's interest (bank, customers, shareholders, etc.) that banking regulators know as soon as possible when a bank is experiencing a significant increase in non-performing assets, which, if left unmitigated, could erode the bank’s earnings and capital base.

?The level of non-performing loans and problem assets held by a bank is a critical indicator of the bank's financial health. When a bank has a high level of non-performing loans and problem assets, it means that the bank is at a higher risk of failure and may not have enough capital to cover its losses. For this reason, banking regulators, investors, and the public need to have access to accurate information about the level of non-performing loans and problem assets held by a bank.

?Regrettably, some banks may attempt to hide the level of these problem assets in order to present a more favorable financial picture to the public.

?Why a Bank May Attempt to Hide Problem Assets

?One reason a bank might attempt to hide the level of non-performing loans and problem assets is to avoid regulatory scrutiny. When a bank has a high level of non-performing loans and problem assets, it is more likely to be subject to increased regulation and supervision by banking regulators.

This increased regulation can be costly and time-consuming for the bank, and it can also limit the bank's ability to make profits. By hiding the level of non-performing loans and problem assets, the bank may be able to avoid increased regulation and keep more of its earnings.

?Another reason a bank might attempt to hide the level of non-performing loans and problem assets is to avoid a run on the bank. When a bank has a high level of non-performing loans and problem assets, it is more likely to experience a run on the bank. A run on the bank occurs when a large number of depositors withdraw their money from the bank at the same time. This can cause the bank to fail, and it can also cause a panic in the financial system. By hiding the level of non-performing loans and problem assets, the bank may be able to avoid a run on the bank and keep more of its deposits.

?A third reason a bank might attempt to hide the level of non-performing loans and problem assets is to avoid a decrease in its stock price. When a bank has a high level of non-performing loans and problem assets, it is more likely to experience a decrease in its stock price. This decrease in stock price can lead to a loss of value for shareholders and make it difficult for the bank to raise capital. By hiding the level of non-performing loans and problem assets, the bank may be able to avoid a decrease in its stock price and keep more of its value.

?A fourth reason a bank might attempt to hide the level of non-performing loans and problem assets is to avoid a loss of confidence in the bank. When a bank has a high level of non-performing loans and problem assets, it is more likely to experience a loss of confidence in the bank. This loss of confidence can lead to a decrease in deposits and a decrease in the bank's ability to borrow money. By hiding the level of non-performing loans and problem assets, the bank may be able to avoid a loss of confidence in the bank and keep more of its deposits and ability to borrow.

A fifth reason a bank might attempt to hide the level of non-performing loans and problem assets is to avoid the bank's reputation damage. When a bank has a high level of non-performing loans and problem assets, it is more likely to experience damage to its reputation. This damage to reputation can lead to a loss of customers and business and a decrease in the bank's ability to attract new customers and business. By hiding the level of non-performing loans and problem assets, the bank may be able to avoid this damage to its reputation and keep more of its customers and business.

Due Diligence is Necessary

Banks can use a variety of methods to hide or mask the level of non-performing loans and problem assets on their balance sheets. These methods can make it difficult for banking regulators, investors, and the public to see the true financial health of a bank. Understanding these methods is important for anyone who wants to evaluate a bank's financial health. A keen understanding of the methods a bank may use to hide problem assets is necessary.

The following are 10 ways banks can hide or mask the level of non-performing loans and problem assets:

1. ?Extending loan terms: Banks can extend the terms of loans to keep them current and avoid classification as non-performing. This can make it appear that the bank has fewer problem assets than it actually does.
2. Rolling over loans: Banks can roll over loans to borrowers who cannot pay, which keeps the loan from becoming non-performing. This can make it appear that the bank has fewer problem assets than it actually does.
3. Forbearance: Banks can give borrowers a temporary reprieve from making payments on their loans, which keeps the loans from becoming non-performing. This can make it appear that the bank has fewer problem assets than it actually does.
4. Loan modifications: Banks can modify the terms of loans, such as reducing the interest rate or extending the repayment period, which keeps the loans from becoming non-performing. This can make it appear that the bank has fewer problem assets than it actually does.
5. Off-balance sheet accounting: Banks can keep assets and liabilities off their balance sheet by using special purpose entities, making it difficult to see the true level of problem assets.
6. Sale-leaseback transactions: Banks can sell assets and then lease them back, which removes the assets from the balance sheet and makes it difficult to see the true level of problem assets.
7. Securitization: Banks can package and sell loans as securities, which removes the loans from the balance sheet and makes it difficult to see the true level of problem assets.
8. Repo-style transactions: Banks can engage in repurchase agreements, which allows them to temporarily transfer assets off their balance sheet and make it difficult to see the true level of problem assets.
9. Fudging numbers: Banks can use accounting tricks to make it difficult to see the true level of problem assets, such as using unrealistic assumptions or creative accounting methods.
10. Pressure on rating agencies: Banks can pressure rating agencies to give favorable ratings to securities backed by problem assets, making it difficult for investors and regulators to see the true level of problem assets.

If the level of activity for Points 1 – 4 above is increasing, it does not always mean a bank is attempting to hide non-performing loans and problem assets. The bank may be trying to provide payment relief to borrowers experiencing financial difficulty. If so, these measures are appropriate and sound credit risk management. However, the bank should recognize that credit risk has increased; therefore, provisions for loan losses should increase accordingly.

Points 5 – 8 require careful inspection and follow-up with the bank regarding the appropriateness of this activity.

Obviously, Points 9 and 10 are out of bounds and could put the bank's senior management team in trouble with banking regulators and legal authorities if discovered.

In conclusion, banking regulators must be alert when conducting on-site and off-site asset quality reviews, closely analyzing the health of a bank's loan portfolio, particularly during times of stress after the economy has weakened. Hiding or masking problem assets can harm the bank in the long run, as it can lead to a buildup of risk and ultimately harm the stability of the bank and the financial system.

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