Loss Leaders for Banks?

One of the latest changes to affect bank practices — and potentially profits — are new rules that seek to limit the scope of so-called relationship banking. A typical deal affected by the rules would be when the commercial lending arm of a large bank gives a corporate client a below-market interest rate on a loan. The reason for the discounted rate: The bank is angling to improve the chances of winning high-margin contracts for its investment banking division, where it would hope to more than make up for any discount.

That once-common practice is being challenged under rules put forth by the Financial Accounting Standards Board (FASB), according to the Financial Times.

Offering below-market interest rates causes banks to misprice risk, say those favoring restrictions on the practice. The financial institutions tend to believe that the kind of relationship banking in question is simply a way of making profits grow, and a discount in one area should not be counted as a loss if it is made up in another area.

Such pricing strategies are “not necessarily unethical,” notes Wharton accounting professor Catherine M. Schrand. “Lots of firms do it – think coupons. Stores offer coupons to get you to shop at their store. Once you are there, you also buy other items at the regular price. Overall, the store is better off by discounting one product.” But problems can arise when customer banking relationships are abused, Schrand adds, which can happen when a bank discounts one product “to gain access to ‘private’ information, which is against the law, or offers discounts with a side agreement about another transaction that should not be negotiated contemporaneously because of Chinese Walls (rules separating commercial from investment banking within the same institution). But engaging in those transactions is unethical (illegal) no matter what the accounting is.”

This latest debate centers on a basic accounting principle: How to account for the transaction price – whether in a purchase or a sale – that very often is the same as the “fair value” price that gets recorded on the books. This makes sense when transactions are “arms-length” — when there are no special, behind-the-scenes deals driving the transaction price lower or higher. And there are already rules out there that require all public firms, not just banks, “to disclose when a transaction price – e.g., the interest rate on debt – does not reflect fair value because it is not an arm’s-length transaction,” Schrand says.

The newest fair-value measurement rules go a step further and offer guidelines for “measuring the fair value of transactions at initiation.” And so, rather than “assuming that fair value equals the transaction price, except when the transaction is with a related party, the new rules basically require that fair value always be measured at initiation. Whenever it deviates from transaction price, firms must disclose why,” Schrand points out. That means the transaction price is no longer automatically “the fair value of the transaction at initiation.” This gives banks less flexibility in their accounting can lead to recorded losses.

“I am in the camp that knowing the ‘correct’ price for any given transaction is best,” Schrand says. Under the new rules, it does not appear the banks will have to “name names.” For example, they will have to report that they loaned a certain amount of money at below-market rates and that the fair value of the loans at initiation was something less than that original amount. The identity of the counterparty – or borrower —  “is not disclosed unless it is a related party.”

Wharton finance professor Richard Herring tends to agree. In principle, the new rules look like “good discipline,” he says. “Relationship lending is a term that can sometimes mask sloppy analysis. If lending at below-market rates is rational, it should be offset by higher profits in some other aspect of the relationship.”

That would be all well and good if all the transactions occurred in the same accounting period, he points out. “The problem that worries some banks, however, is that the cost may occur in an accounting period before the incremental revenue and so it may distort actual earnings. Put another way, the earnings would be positive if an appropriately longer accounting period were used.”

It is worth noting that FASB has recently reversed other plans to tighten some wide-ranging accounting rules for banks — most notably it abandoned an effort to force banks to mark loans on their books to market, according to the Financial Times article.

Citing Knowledge@Wharton

Close


For Personal use:

Please use the following citations to quote for personal use:

MLA

"Loss Leaders for Banks?." Knowledge@Wharton. The Wharton School, University of Pennsylvania, [23 March, 2011]. Web. [23 October, 2014] <http://knowledge.wharton.upenn.edu/article/loss-leaders-for-banks/>

APA

Loss Leaders for Banks?. Knowledge@Wharton (2011, March 23). Retrieved from http://knowledge.wharton.upenn.edu/article/loss-leaders-for-banks/

Chicago

"Loss Leaders for Banks?" Knowledge@Wharton, [March 23, 2011].
Accessed [October 23, 2014]. [http://knowledge.wharton.upenn.edu/article/loss-leaders-for-banks/]


For Educational/Business use:

Please contact us for repurposing articles, podcasts, or videos using our content licensing contact form.

 

Join The Discussion

No Comments So Far