Bigger than Loan Impairment – Adjusting Bank Profits for Inflation

We have been covering loan impairment for the past few weeks, and the FASB's proposals leave me with the feeling that we will be discussing it for a long time to come. Once the FASB shoves its post-WWI-Germany-derived "Current Expected Credit Loss Model" through the meat grinder that it refers to as "due process," the banking oligarchs will be mollified, and financial results will hum right along again … for maybe a decade. After the next tsunami of bank insolvencies will hit without warning; my best hope is that accounting standards setters (it might not be the FASB that far out) will finally adopt a credible process for marking bank loans to market.

Now that I'm finished with loan impairment, as long as we're on the topic of the accounting for banks, let's move on to another topic that could prove to be even more important between now and the next balance sheet bubble. In this post, I'll be discussing the accounting for inflation – or rather the lack of accounting for inflation. Only for the sake of whetting your interest, let me state that if you believe the conservative naysayers, imprudent monetary policy is raising the inflation specter. But, what I really want to show is that reflecting the effect of inflation on bank financial statements is important even now.

The Effect of Inflation on Accounting in a Nutshell

When a bank originates a fixed-rate loan, monetary inflation inevitably erodes the purchasing power of the contractual cash flows to be received in the future. Even if the bank were repaid in full at some point (i.e., setting aside all impairment concerns) the return of its principal is worth less 'today' than in the past, when the loan originated. Bankers realize this, of course, and should charge a rate of interest that is commensurate with the expected loss of purchasing power of its future cash inflows.

But, despite the straightforwardness of the problem, there is a huge accounting disconnect between economic reality and what is actually reported.  The lessons I intend to convey by a representative, yet simple example, are the following:

• Reported bank profits are always overstated by U.S. GAAP (or IFRS) by the absence of any rules requiring banks to recognize the declining purchasing power of the value of loan portfolios.
• Reported bank profits are always less volatile than their economic profits.
• If you believe, as I do that what gets measured gets done, then shareholder value destruction occurs: loans are mispriced because the full of effect of a manager's lending decisions are not reflected in management's scorecard, i.e., net income for the period; and dividends may unintentionally shrink a bank because they are greater than the banks true (economic) earnings.

Here's the example – and I hope you'll bear with me because I'm going to need more than a modicum of words, numbers and pictures to demonstrate the above points:

• NewBank was established on January 1, 20x0, on which date it engaged in the following transactions:
  • Shareholders contributed $20,000 in cash;
  • The bank borrowed $80,000 in the form of a bond paying interest at 4% at the end of each year for five years.
  • The bank originated a $100,000 loan with terms identical to the bond, except the interest rate charged was 5%.
• New Bank made its bond payments as scheduled, and its borrower did the same.
• Annual dividends were $1,800. (Note that this is the amount of net interest received each year. Also, since the bank has no other revenues or expenses, it is the amount of income reported in U.S. GAAP each year.)
• Inflation for each year was as follows: 2% in the first year, followed by 4%, 6%, 4% and 2% for each succeeding year.

Below are the financial statements for the each year, but I want to first focus on 20x1. (By the way, you can access my full spreadsheet here.  Among other things, it will show you to the purchasing power loss item is calculated.)

The first thing to notice is that the bank's inflation-adjusted income in the first year (and every other year), which henceforth I will refer to as economic income, is lower than its GAAP income. In the presence of inflation, this will almost always be the case, because there is nothing the bank can do about the fact that it holds more monetary assets that are exposed to inflation than monetary liabilities. I have displayed the effect of loss of purchasing power on economic income in a separate line item.

A couple other things to take note. First, that revenues and expenses were inflated. More generally, all measurements are made in "constant" units of purchasing power, which simply means that we are adjusting (i.e., remeasuring) past revenues, expenses, assets and liabilities to reflect their purchasing power as of the end of the most recent period.

But, for a bank, these remeasurements are not as consequential as for an industrial company that would, for example, have to remeasure depreciation expenses from long-ago capital expenditures in the dollars of today.

Second, the inflation adjustments made in the financial statements only require actual inflation as inputs; no assumptions about the difference between expected versus actual inflation are made. In fact, we have no way of directly knowing how much inflation was impounded in the interest rates charged by the bank as a lender, or to the bank as a borrower.

To get a sense of the long-run effects of remeasuring for inflation, the chart below displays the time series of GAAP income versus economic income over the full five-year terms of the loan and debt:

The biggest takeaway here is self-evident: that changes in inflation will add an element of volatility to reported earnings. Conversely, ignoring inflation makes reported earnings quite easy to predict. Even when inflation runs amok, NewBank's reported earnings misleadingly appear to be like a rock of consistency.

The $64-K Question

Should the FASB require banks to adjust for inflation? The reasons why they should are:

• Bankers can be expected to make better decisions if better information is provided to shareholders, i.e., their putative bosses. If you believe that adage 'what gets measured gets done' then you have to believe that shareholders are losing value every day that a clearly inferior accounting standard is in place.
• Making inflation adjustments to a bank's accounts is simple (I'm setting aside other industries here, also mainly for the cause of simplicity). As I demonstrated in my worksheet, inflation adjustments are not rocket science; they are easy to program, and are a lot easier to explain than, say, the CECL model or hedge accounting.
• When banks choose a dividend payout ratio based on GAAP earnings (the ratio is 100% in my example), it is impossible to tell whether the dividend exceeds economic earnings.  Stated another way, a portion of the dividend will be merely a return of investment, as opposed to a return on investment. Among the consequences are that bank executives own shares in their banks, so GAAP-based dividends risk that the executives will be receiving the invested monies of shareholders instead of an earned share of investment income. In the extreme case, when inflation is high, we can expect bank executives to seek a raise in their compensation – even while economic income is surely negative.

As far as I can tell, there is only one reason why inflation-adjusted financial statements shouldn't be required. You guessed it: bankers will throw a fit.

It will make their recent protestations to the FASB against marking loans to market feel like a book club debating 50 Shades of Grey.

Comments

[Independent Accountant]

TS:
I've been saying things like this for decades.

IA