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Is the House of Lords’ Crisis Inquiry Putting the FCIC to Shame?

January 29th, 2011

The many inquiries into the financial crisis have turned over plenty of stones but have failed to find any smoking guns. But the House of Lords economic affairs committee’s inquiry “Auditors: market concentration and their role” is making strides in identifying and maybe rooting out the accounting shenanigans that lay at the heart of the crisis.

At a recent session of the HoL inquiry, UK-based investors said that IFRS (international financial reporting standards) had encouraged imprudent, reckless and even illegal behavior by UK and Irish banks, enabling them to deceive investors, boost executive bonuses and ultimately destroy their institutions at taxpayers’ expense. (See text pages 72-73 of this report for a fuller explanation of the shortcomings of IFRS)

The investors told the Lords – who included the former UK chancellor Lord Lawson (pictured above) – that IFRS had enabled bank boards and auditors to present their institutions as massively profitable, when in fact they were barely profitable or even loss-making — and all in ways that auditors could invariably claim “complied with the standards”.

In turn this enabled the banks to make imprudent payouts to executives (in the shape of bonuses) and to shareholders (in the shape of dividends) which in truth they could not afford to make.

In an article published in May 2009, Brandon Davies, managing director of the Global Association of Risk Professionals Risk Academy said the switchover from UK GAAP to IFRS in 2003-05 had prompted banks to recategorize assets on their balance sheets in dangerous ways:-

Under Basel II … a bank is incentivized in the growth phase either to acquire more assets to increase income or to repay surplus capital to its shareholders. In the contraction phase of the cycle, the systematic deterioration in credit quality requires an increase in capital resources to maintain the same total of balance sheet assets, or a significant reduction in the amount of assets supported by a given amount of capital.

IFRS has produced a significant effect on capital ratios, because any fall in the price of an asset in the accounting categories ‘available for sale’ and ‘held for trading purposes’ produces a reduction in capital by the amount of the fall in price, as will happen in the contraction phase of the economic cycle, or an increase in capital as asset prices rise in an expansionary phase of a cycle.

In practice, these two accounting categories for assets cover a much greater proportion of the assets on banks’ balance sheets than was the case for ‘mark to market’ assets under the old UK GAAP. This is because the new categories cover any assets where there is an intention to sell the assets. Such assets are often held for prudential regulatory purposes in the banking book, which is actively managed as with any investment portfolio. This has led to many relatively illiquid and long-term assets (such as loans to private equity, securitized assets such as mortgages and illiquid bonds) being covered by these categories. The effects on regulatory capital are, moreover, exaggerated, as prices are also affected by an increase in liquidity in the growth phase of a cycle, and by a decline in market liquidity in the contraction phase.

IFRS’s biggest flaw, however, is that it gave bank managements and their auditors too much latitude in the valuation of assets, which in the upcycle created an illusion of capital strength and egged managements to indulge in more and more poor quality lending, creating a Ponzi-like scenario in the frothiest market sectors. It also enabled bank managements to make ludicrously low provisions for bad debts.

According to a transcript, Iain Richards, head of corporate governance at Aviva Investors, said:-

…you get—and I will characterize it slightly—a finance director will approach the auditor and say, “What’s the range of fair values that would be acceptable under the standards?” The auditor might say, “Well, it’s between 70 and 140 and we think the reasonable prudent number would be about 95”. The FD says, “Thanks, 140 is just what I was looking for. Thank you very much”, and it’s compliant with the standards. I’m exaggerating but the auditor is then in an invidious position of having very little leverage under the way that the standards work to push back on that.

IFRS is pro-cyclical is that it allows mispriced credit to go unchecked. It enables banks to price risky loans as if they were safe loans. While the pro-cyclicality of IFRS has been widely recognised, experts say the problem was exaggerated in the UK as a result of the way it was implemented. Richards added:

IFRS [as applied in the UK] is extremely pro-cyclical. It facilitated and exacerbated the credit bubble and then brought it home to roost in the crash and crisis. [In bank financial statements] there were valuations that frankly [were not] rigorously carried out on some instruments where reliance on netting off against credit default swaps was fictional given that the CDS market, which hit US$66 trillion at its peak, was 80% naked and the counterparties could never meet their exposures. Reliance on an instrument like that to support a toxic instrument that you are carrying on your balance sheet is imprudent — but it’s acceptable and allowed under the standards.

In a letter to the Times dated 27 July 2010, a group of academics and accountancy experts said “In its commencement phase, the ‘fair weather’ model significantly overstated bank profits, resulting in excessive dividends. It also obscured true gearing and capital destructive business models. In “storm” mode it accelerated and exaggerated losses, resulting in taxpayer-funded recapitalizations.”

Aviva’s Richards added:

The double-digit billions pumped into the banks went to plug the gap created by both bonus distribution and dividend distributions that were made just preceding the crisis.

His stark assessment was endorsed by other fund managers in the HoL session, including David Pitt-Watson of Hermes; Guy Jubb of Standard Life Investments; and Robert Talbut of Royal London Asset Management.

And Pitt-Watson said:

If we had had more conservative accounting, then the profits and the equity of the banks would have been lower; the bonuses wouldn’t have been so big; they wouldn’t have loaned out so much more money. I am intrigued that when HBOS was taken over by Lloyds that, of their £432bn loan book, Lloyds said £186bn of that was not business that they would’ve wished to do. It would have been helpful … if whoever was auditing HBOS had said, “Your loan book seems to us to be rather different from the loan books that we’re finding in other banks.

Under IFRS/mark-to-market accounting, HBOS auditors KPMG were not required to differentiate between what appears to have been “phoney” lending by the Edinburgh-based bank to a labyrinth of already insolvent corporate borrowers and shady off-balance-sheet vehicles and kosher corporates that were genuinely capable of repaying their loans.

Pitt-Watson said that “we as investors and society” need to see the re-introduction of a principle-based accounting system that includes prudential and on-going assessments of risks.”

The fund managers’ concerns about IFRS echoed those of Tim Bush, a former fund manager at Hermes and a member of the UK’s “Urgent Issues Task Force” that is tasked scrutinizing the work of the Accounting Standards Board.

Last August, in a letter sent to the ASB, the BIS and other accounting regulators, Bush said the ASB’s failure to properly understand IFRS had caused it to implement the standards in a way that contravened the Companies Act.

Bush said the ASB had failed to get its head around the law relating to creditor protection, which is embedded in the Companies Act (which applies to companies using IFRS and those using “UK GAAP” ) As a result, said Bush, the ASB had approved standards that contravened the law in respect of creditor protection.

Overall Bush said the way in which IFRS had been implemented in the UK and Ireland had “created ‘double dose’ to the extent of being a deadly dose, by removing what had underpinned banking solvency for over 120 years”, leaving UK and Irish banks dependent on a different (flawed) set of financial reporting standards to their counterparts elsewhere Europe.

Bush also said the use of IFRS had prompted the boards of UK banks to make illegal payouts to executives and to shareholders:

Overstating profits could lead to an illegal distribution (which is a criminal offence), as well as a breach of Section 386 (also a criminal offence). Some aspects of IFRS do overstate profits and indeed several UK and Irish banks collapsed after paying dividends. They did not have the capital that they presented, and they were not going concerns. The true situation was that business models were loss-making and actually consuming capital. The accounts were unreliable for capitalism to function properly as they did not show the capital.

Bush that IFRS, as applied in the UK and Ireland, had created phantom bank profits and phantom capital that had “misled creditors, misled shareholders, the Bank of England, FSA and others”. He claimed this had led to the “regulatory fiasco” that had caused the financial crisis and, owing to the authorities’ insistence on sticking with IFRS despite its flaws, continued to pose a severe risk to the financial system.

This article was first published in Naked Capitalism on January 27th, 2011

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