The Net-Net on Netting… and Risk

We’re the first to admit it: accounting isn’t easy… and that includes derivatives accounting. But it’s not exactly rocket science, either.

So we always feel mixed emotions (equal parts sympathy and dismay) when an article tries to cover an important derivatives accounting issue. A case in point: the recent Bloomberg story, US Banks Bigger Than GDP as Accounting Rift Masks Risk. The article is basically a criticism of the current US accounting treatment of OTC derivatives. We published a paper on this not long ago.

The US Financial Accounting Standards Board (FASB) permits the netting of exposures between counterparties on financial statements. This treatment mirrors the fact that in a number of jurisdictions, “netting IS DA law” (as we like to say around here). This means that netting is legally enforceable – a fact of law – and recognized as such by courts, regulators and market participants.

As a result, the accounting, legal and regulatory views on netting for US-based companies are aligned. So the outlier in this situation is actually the International Accounting Standards Board’s rules. These rules ignore the legal and regulatory consensus on netting and require firms to report their gross positions.

One result of all of this is that non-US firm balance sheets are larger than US firms’. We believe this ballooning of the balance sheet is artificial by virtue of the inclusion of both gross derivative assets and gross derivatives liabilities. The net amount is a better reflection of risk. For this reason, financial statements based on the FASB rules are more transparent.

Another result of the differences in approach is that firms deal with investors who are familiar with one, the other, or both sets of accounting rules. So firms also publish in their annual financial statements information that would be required if they followed the other set of accounting rules. In other words, firms that reflect net exposures in their balance sheets disclose the gross numbers in the footnotes.

That concludes the sympathy part of the emotional equation. Now on to the dismay part.

Despite what the Bloomberg story’s headline claims, risk is not being masked by the FASB rules. What’s being masked (in the story, at least) is the role of netting in reducing risk. In addition, in commenting on the size of derivatives exposure, the article could have made it clear that it was referring to notional amounts outstanding, which are not an accurate reflection of risk. As the BIS has published (and as can be seen in our
most recent Market Analysis
), the gross market value of outstanding OTC derivatives (at June 30, 2012) was about 4% of notional. After factoring in the impact of netting, credit exposure was 0.6% of notional. Collateralization reduces that credit risk even further.

So, net-net, netting does not mask anything. It actually presents the true face of risk.