How Banks Calculate Their Write-Downs

The WSJ has a fabulous "Heard on the Street" column today, worrying about all these losses being announced by big universal banks: Citi, UBS, Deutsche. Are they worried that the losses are so big they will damage the banks' franchise? No: the worry is rather that the banks might be overstating their losses:

While there is no evidence to suggest the banks are doing anything wrong, numerous academic studies show that discretionary valuations related to possible losses, which are often based on estimates, are an area of financial statements that has in the past been manipulated by executives to manage earnings.

Doubtless there is some of this going on: if you're going to write off, say, $2.5 billion, you might as well make it a round $3 billion (that seems to be the standard write-off these days), thereby giving yourself a bit of cushion against further losses and possibly a nice bit of extra upside with which to pad future profits.

On the other hand, all of these numbers are by their very nature inexact at best, and I'm sure that most shareholders would prefer, in the present environment, that these banks err on the side of caution.

Of course, the banks have to maintain the fiction that all these numbers are entirely objective and accurate to umpteen decimal places:

Deutsche Bank said it "continues to apply accounting and valuation principles consistently with prior periods." A UBS spokesman said the bank's markdowns "are appropriate and follow established accounting principles and industry standards." A Citigroup spokesman said the bank "has taken impairments in the third quarter based on a rigorous process applying appropriate accounting principles."

I somehow doubt that anybody outside these banks considers the quality of their earnings reports to be particularly consistent or rigorous, so I'm not entirely sure who the banks think they're kidding. What would happen if a bank decided to be honest, and simply said something like this?

"We have a lot of very hard-to-value securities on our books, we know they've fallen in value, but we can't say how far with any exactitude, so we're going to take a large $3 billion write-down which should be more than enough to cover any losses associated with the debt portfolio."

I have a suspicion that the sun would still rise the following morning. Although you can never be sure.