A bank’s balance sheet total is not necessarily stable – even if a bank does not buy or sell assets. The value of the assets is in fact variable. A building can become more or less valuable, the value of a brand can increase or decrease. International IFRS accounting rules require a bank to pass on those fluctuations in its balance sheet for some of its assets.
Shifts on the asset side
Broadly speaking, the asset side of the bank balance sheet shows three categories of ‘financial’ assets. Long-term loans that remain in the books until maturity (for example, thirty-year mortgages) are hold to maturity according to international accounting rules. This means that they remain in the books at the purchase value until they are paid out. If, for example, the house linked to the mortgage rises or falls in value, that fluctuation in value has no effect on the bank’s balance sheet total.
The assets in the trading portfolio, on the other hand, are intended to be resold as soon as possible. They are in the books at the value of the day. Typically, no long-term sustainable financing is required to keep them on the books, as they are generally resold quickly.
Between those two categories, there are financial assets that are listed as available for sale. These are assets that the bank may hold until maturity, but may also sell in the meantime. A significant part of the assets of Belgian banks (many government bonds, for example) are placed in the latter category. For example, the financial institutions have their hands free in case a buyer shows up with an interesting offer.
Frozen financial markets
The consequences of that choice became clear during the crisis. The market value fluctuations of, for example, government bonds became (and become) immediately visible in the bank’s books as a result of the accounting rules. If the market price of Spanish government bonds collapses, or if the banks decide to write down their Greek government bonds to 30% of their nominal value, this creates a problem for banks that have such bonds in their available for sale portfolio. Then the value of those bonds falls in the asset column of their balance sheet, and that impairment must then be adjusted from the bank’s equity.
When a bank eats its own equity from the right side of its balance sheet, it must immediately replenish that equity in order to meet capital requirements and remain solvent. When the financial crisis hit the bottom of the equity markets, the government was often the only party that could be found willing to step into the (equity) capital of a troubled financial institution and thus adjust the deficits in equity were caused by the decline in the market value of the assets.
But market value is by definition virtual: it represents a price that the market players want to pay for a financial product at one point, but does not necessarily reflect the real intrinsic value of such a product.
However, a lack of capital was not the only problem facing certain banks during the crisis. A serious liquidity problem also arose, as too many long-term assets in the balance sheet were refinanced with short-term loans on the financial markets. When the financial markets closed the money taps, that lever broke a number of banks.
Bank for International Settlements
Before the Basel III capital rules, the equity of a healthy bank amounted to between 3% and 6% of the balance sheet total. That amounts to a leverage between 17 and 33. Now that the central bankers at the Bank for International Settlements in Basel decided to tighten the capital rules for banks, shareholders’ equity will increase significantly in the coming years and the leverage will be reduced.
This has already happened in Belgium. The balance sheet total of the Belgian financial sector has decreased by almost 30% since 2008. The dependence on the financial markets has decreased and the term of the financing has been extended. So there is less refinancing, and the need to call on the financial markets is less frequent.