Wednesday, 24 October 2007

Conduits and Consolidation

Bloomberg has an interesting article Citigroup SIV Accounting Looks Tough to Defend. The author, Jonathan Weil, makes the point that Citi is caught between the devil and the deep blue sea:
  • If it supports its SIVs, accounting consolidation kicks in since the firm is deemed to be providing implicit support and under FASB Interpretation No. 46(R) that brings them back on balance sheet.
  • If it doesn't support its SIVs, the reputational damage will be severe.
Weil argues this is one of the reasons for the MLEC plan: it would allow Citi to dig some of SIVs out of the mud without forcing it to consolidate. This is a good point and it might well be true. But there is another dimension, too: regulatory consolidation. It is a little known (if deeply, deeply boring) point that regulatory consolidation is not the same as accounting consolidation.

Regulatory consolidation very roughly works by identifying which parts of the group are financial, putting all of their risk on the top company balance sheet, subtracting the equity invested in non-financial subsidiaries, and calculating regulatory capital on the result. Accounting consolidation again very roughly seeks to identify whether an entity which a firm has a relationship with is controlled by, owned by or gives the results of its activity to the firm. If so, that entity is consolidated. In detail the topic is complex, particularly in the context of firms which have both banks, insurance companies and other activities in a single group - financial conglomerates - or where careful structuring has been used to try to dodge the consolidation provisions of IAS 27, SIC 12 or whatever for a given securitisation SPV, SIV or conduit. For now, though, note that in principle at least an entity can be consolidation for accounting purposes but not regulatory purposes and vice versa. And that's fairly odd. I can see that it makes sense to deconsolidate non-financial subsidaries of a financial holding company for regulatory capital purposes. I can even see how you might want to treat the same risk in different operating companies differently - for instance if a holding company owns both a bank and an insurance company. But the idea that an entity such as a conduit is consolidated for accounting purposes but not for regulatory capital seems deeply imprudent. And of course many conduits have been structured to ensure that provided no implicit support is given they will not consolidate for either purpose.

It is worth noting that for FAS accounters, FIN 46(R) on the Consolidation of Variable Interest Entities includes provisions for the recognition of an implicit variable interest, aka implicit support. This occurs amongst other things when a bank provides a conduit with credit or liquidity support that it is not contractually obliged to provide.

That brings us to the heart of the dilemma. Implicit support is poison. Regulators and auditors can only spot it after it has happened. But if conduit paper has been sold with a nod and a wink, so that the buyers expect implicit support and will exact reputational damage if it is not provided, then there is something rotten in the state of finance.

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