26 June 2011
My work on the flawed nature of “mark-to-market” accounting and IFRS accounting standards has been included as supporting evidence in attempts by Steve Baker, the Conservative MP for Wycombe, to introduce to the UK parliament a private members bill that would transform how banks report their financial performance.
Baker, a former Lehman Brothers executive, introduced the bill under the “10-minute rule” on March 15th, with a view to bringing greater clarity to banks’ accounts — in particular how they account for derivatives holdings.
His Financial Services (Regulation of Derivatives) Bill would require banks to hold two parallel sets of books. One would mark banks’ holdings to market, as is the practise under IFRS, and the other would require them to assess their value based on historic cost. Baker proposes that banks should be required to adopt whichever is the lower of the two values. Baker said the bill is designed “to expose banks’ false profits, overstated capital and hidden losses”.
A press release said that “EU-mandated International Financial Reporting Standards (IFRS) are forcing UK and Irish banks to deceive themselves and all their stakeholders about their true financial positions. These accounting standards have contributed enormously to the severity of the financial crisis in both countries, and pose a lethal threat to any recovery. Baker said that auditing banks under IFRS means that their true solvency is not accounted for and that banks which seem profitable under IFRS may in fact be loss-making and destroying their capital. This was almost certainly true of both RBS and HBOS in the two to three years prior to their 2008 collapses.
“When I introduced my Bill on 15 March, I explained how the accounting rules for banks incentivize trading in derivatives by enabling unrealized (and, indeed, fake) profits to be booked up-front, leading to large but unjustified bonuses and dividends.
“On 30th March, the House of Lords Economic Affairs Committee published a report recommending that the government reassert prudence as a guiding principle and ensure that accounts are reliable. That is exactly what my Bill does and I hope the Government will adopt it.
“While complying with the rules, banks are producing accounts that grossly inflate their profits and capital in three ways. First, using IFRS mark-to-market and mark-to-model accounting, banks record unrealized gains in investments as profits. Second, IFRS prevents banks from making prudent provision for expected loan losses by allowing recognition only of incurred losses. Third, IFRS encourages banks not to deduct staff compensation from profits. Taken together, these flaws mean that banks’ accounts under IFRS are at once rule-compliant and dangerously misleading.
“By way of example, we have deduced from the accounts of the UK Asset Protection Scheme that RBS may be overstating capital by as much as £25bn.
“Boards take decisions based on their accounts. If the accounts are misleading, is it any wonder that boards and regulators are failing shareholders and taxpayers? The public are furious about the injustices manufactured by the banking system, and they are right to be, but how much greater is the injustice if grotesque bonuses are based on false profits?
“Banks are living in a fools’ paradise in which their boards cannot get a firm grip on vital measures like capital and profit. That is plain wrong.
“Thanks to the European Union, the UK cannot simply mandate prudent accounting in compliance with UK Companies Law but we can require parallel accounting to British standards while international negotiations proceed. That is why I am calling on the Government to adopt my Bill.”
The Financial Services (Regulation of Derivatives) Bill was scheduled for second reading with other private members’ bills on June 10th, 2011. However it was “not moved” on that occasion.
My articles on the topic include:-
Thanks to IFRS, Irish and UK banks have lived in a fool’s paradise for years … and they’re still residing there September 6th, 2010, Qfinance
Scrap mark-to-market accounting or face further crisis, warn investors January 14th, 2011, Qfinance
Is the House of Lords Crisis Inquiry putting the FCIC to shame? January 27th 2011, Naked Capitalism