Bank Rule Distorting Performance Is Repealed
It stated that banks could choose to value some of their liabilities, the money they owe, according to fair value. And in doing so, the accounting rule allowed a bizarre treatment when a bank was under stress. If a bank is ailing, investors have less desire to lend to the bank. As a result, the value of the bonds that the bank has issued might fall. The rule then assumed that the bank could, in theory, buy back those distressed bonds at a discount. By doing this trade, a bank would create profits for itself. The bond’s covenant might require the bank to pay back 100 cents on the dollar to its holders when it matured. But if the bank itself bought the entire bond for 70 cents on the dollar, it would avoid having to pay the bond back at 100 cents — and the 30 cents it would not now have to pay back would become a gain in its earnings statement.
.. But the rule also punished the banks’ earnings. When investors’ perceptions of a bank’s creditworthiness improved, its liabilities would in theory rise in value. As a result, a bank would make less of a gain if it bought back its own debt — and this would show up as a loss in a bank’s earnings.