Large US banks have reduced hard-to-value Level 3 assets since the beginning of the year, according to quarterly filings, but it doesn't mean their balance sheets are in better shape.

The decline was modest for some banks, especially compared with the sharp improvement in 2009 when banks raised equity and reduced leverage. In addition, the recent requirements to consolidate off-balance sheet vehicles helped remove some assets from the Level 3 bucket--but only to reclassify them under different categories on balance sheets.

"The true extent of the risk reduction in the first half of 2010 is distorted by the consolidation of variable interest entities, which was required by the new accounting rules at the start of the year," wrote Moody's Investors Service in a report Monday. "When all the assets of a VIE are brought back on to the balance sheet, the previous investment in the VIE recorded on the balance sheet is eliminated."

At Citigroup, Goldman Sachs and JPMorgan, for example, the consolidation of credit card securitization trusts wiped out securities previously reported as Level 3 retained interest from securitization. Reported Level 3 assets may decline, but the risks of these assets remain on balance sheet and are reported elsewhere.

At Citigroup, Level 3 assets went from $72 billion to $64 billion, but there was an $8 billion reduction from the net VIE impact.

Moody's reckons the value of Level 3 assets will remain about the same in the near term, which means that from this perspective, the lending ability of large banks isn't improving for now.

"We don't expect Level 3 assets to decline much further given the pressure investment bank managers face to produce shareholder returns," according to Moody's. "Level 3 assets, although risky owing to their illiquidity, often have attractive yields and wide bid-offer spreads."