US GAAP accounting standards may offer a misleading picture of leverage among five of the largest American banks relative to their European counterparts, because US banks net out derivatives exposure when calculating total assets.

Chart 1 - RWA

In September 2011, Jamie Dimon, chairman and CEO of JPMorgan Chase & Co, launched a stinging critique of Basel III capital adequacy calculations, which he claimed discriminated against US banks. A key part of the complaint is that European banks have been more willing to play the Basel risk-weighting system used to calculate assets. As a result, European banks may record a high BIS capital adequacy, even while their gross capital-to-assets ratios are significantly lower than those for the top US banks.

Our rankings appear to bear out that criticism. A number of European banks such as Credit Suisse, UBS, Société Générale and Deutsche Bank, have Basel risk-weighted assets (RWA) of less than 30% of gross total assets – or less than 20% in the case of Deutsche and UBS. By contrast, the aggregate ratio of RWA to total assets for the top six US banks is almost 58%. Even excluding Wells Fargo, which has a more plain-vanilla banking business than the other five, the ratio is still 55% (see chart 1).

But this is not the whole story. There is a significant difference between US Generally Accepted Accounting Principles (GAAP) and the International Financial Reporting Standards (IFRS) used in Europe, in terms of how they account for derivatives exposure. GAAP allows banks to net out most of their derivatives positions, whereas IFRS requires banks to show something closer to the gross total. So the higher ratio of RWA to total assets seen in the US is not just down to Europe underestimating RWA. It could also be that US banks are underestimating gross assets.

Not so different after all

Indeed, if US banks accounted for their derivative assets using the IFRS methodology of recording derivatives on a gross basis, their capital-to-assets ratios would not look so different from those of the Europeans (see chart 2). Analysts at Credit Suisse made these calculations using US GAAP accounts for 30 September 2010, and we have added in our own IFRS numbers for European banks as at 30 December 2010. Barclays supplies figures in both formats, a legacy of its Lehman US purchase. Interestingly, Credit Suisse itself reports its numbers only in Swiss GAAP format, which treats derivatives in a similar way to US GAAP.

So who is right? Both sides have a point. Clearly, matched derivatives positions are not normally a drain on the balance sheet, because any move in the market will leave the net position unaffected. But the financial crisis has brought out several reasons to keep an eye on gross derivatives exposure – most obviously the counterparty risk assumed in derivative transactions. And some netted derivative positions may not match exactly – they may, for instance, have different maturities, even though they reference the same asset. This could leave the bank exposed to basis risk during periods of acute market volatility, which are all too frequent in the current market.

Basel III seeks to pay more attention to those risks, and the ratio of RWA to total assets is set to rise for both US and European banks under the new capital regulations. The US accounting standards board is contemplating whether to switch to an IFRS-style method to bring US principles more into line with the spirit of Basel III. But whoever wins the debate, one lesson for investors is clear – leverage at the top American banks is not much less than the levels at their European peers.

AMMEND Mind the GAAP

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