September 16, 2010 by MICHAEL RAPOPORT, WSJ

 

Federal regulators are poised to propose new disclosure rules targeting “window dressing,” a practice undertaken by some large banks to temporarily lower their debt levels before reporting finances to the public.

 

The US Securities and Exchange Commission is scheduled to take up the matter at a meeting Friday and is expected to issue proposals for public comment. The action follows a Wall Street Journal investigation into the practice, which isn’t illegal but masks banks’ true levels of borrowing and risk-taking.

 

 

A Journal analysis of financial data from 18 large banks known as primary dealers showed that as a group, they have consistently lowered debt at the end of each of the past six quarters, reducing it on average by 42% from quarterly peaks.

 

The practice suggests the banks are carrying more risk than is apparent to their investors or customers, who only see the levels recorded on the companies’ quarterly balance sheets.

 

The SEC focus comes two years after the peak of the financial panic, which was exacerbated by high levels of borrowing by the nation’s banks. Since then, heightened scrutiny from regulators and investors has prompted banks to be more sensitive about showing high debt levels.

 

The SEC is expected to propose rules requiring greater disclosure from banks and other companies about their short-term borrowings.

 

The agency’s staff has been considering whether banks should be required to provide more frequent disclosure of their average borrowings, which would give a better picture of their debt throughout a quarterly period than do period-end figures. An SEC spokesman declined to comment.

 

Short-term borrowing pumps up risk-taking by banks, allowing them to make bigger trading bets.

 

Currently, banks are required to disclose their average borrowings only annually, and nonfinancial companies aren’t required to disclose their average borrowings at all.

 

Last month, Sen. Robert Menendez, a New Jersey Democrat, and five other senators urged the agency to require more disclosure so the public could see if a company tried to dress up its quarterly borrowings.

 

“Rather than relying on carefully staged quarterly and annual snapshots, investors and creditors should have access to a complete real-life picture of a company’s financial situation,” the senators wrote to SEC Chairman Mary Schapiro, citing the Journal articles, among other things.

 

Ms. Schapiro, through a spokesman, declined to comment. Mr. Menendez’s office didn’t return a call.

 

Some large banks, including Bank of America Corp. and Citigroup Inc., frequently have lowered their levels of repurchase agreements, a key type of short-term borrowing, at the ends of fiscal quarters, then boosted those “repo” levels again after the next quarter began.

 

The banks have said they are doing nothing wrong, and that the fluctuations in their balance sheets reflect the needs of their clients and market conditions.

 

But the practices suggest the banks are more leveraged and carry more risk during periods when that information isn’t disclosed to the public.

 

At Friday’s meeting, the SEC also will consider additional guidance for companies about what they should disclose about borrowing practices in the “Management’s Discussion and Analysis” sections of their securities filings.

 

In the wake of the financial crisis, the SEC’s staff has been taking a fresh look at companies’ disclosures in these “MD&A” sections about liquidity and capital resources.

 

In the SEC staff’s view, balance-sheet fluctuations can happen for legitimate reasons, and the important thing is disclosing them to investors when they are material.

 

Concern about hidden risk-taking by banks was heightened after a March report about the collapse of Lehman Brothers Holdings Inc.

 

A bankruptcy-court examiner said Lehman had used a repo-accounting strategy dubbed “Repo 105” to take $50 billion in assets off its balance sheet and make its finances look healthier than they were.

 

The SEC later asked major banks for data about their repo accounting. SEC Chief Accountant James Kroeker said in May that the commission’s effort hadn’t uncovered widespread inappropriate practices.

 

Still, both Bank of America and Citigroup found errors in their repo accounting that amounted to billions of dollars, though these were relatively small in the context of their giant balance sheets.

 

An investigation by the SEC’s enforcement division into Lehman’s collapse is zeroing in on this Repo 105 accounting maneuver, according to people familiar with the situation.

 

In an April congressional hearing, Rep. Gregory W. Meeks, a New York Democrat, asked Ms. Schapiro about the Journal’s findings regarding banks’ end-of-quarter debt reductions.

 

“It appears investment banks are temporarily lowering risk when they have to report results, [then] they’re leveraging up with additional risk right after,” Mr. Meeks said. “So my question is: Is that still being tolerated today by regulators, especially in light of what took place with reference to Lehman?”

 

Ms. Schapiro said the commission is gathering detailed information from large banks, “so that we don’t just have them dress up the balance sheet for quarter end and then have dramatic increases during the course of the quarter.”

 

Write to Michael Rapoport at Michael.Rapoport@dowjones.com  

 

Source: Proshare