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How banks get away with inventing profits | Gordon Kerr

Abetted by a sloppy bailout structure, bankers now produce financial statements that would make Bernie Madoff blush

Both sides of the political divide are in agreement that bailing out the UK’s failed banks in 2008 (and Northern Rock in 2007) was the right decision. Taxpayers were told that the worst of all possible worlds would have occurred had banks been allowed to fail.

By bailing them out, and by encouraging them to continue to reward executives on pre-crisis pay scales and incentives, politicians prophesied that things would be fine, and management were incentivised to hope that things were fine. The cream of banking talent would remain at the helm of each bank, steadying the ship, ensuring that liquidity would flow through the national economy, which would soon be back on its feet.

Both sides are wrong. The banking crisis is now out of control, made worse by the sloppy bailout structure. The format of the bailout, and the perverse incentives for managers created thereby, have encouraged senior executives to produce financial statements that are still exaggerating profits and capital to an extent that would make Bernie Madoff blush.

Let me set out three examples of how bankers declare profits despite running loss-making operations as defined by prevailing UK company law, some of which were acknowledged by the Bank of England’s Andy Haldane on Thursday:

1. Underprovisioning for expected losses, resulting in loans being carried at more than their recoverable amounts

Example: The July 2010 accounts of HM Treasury’s asset protection scheme (APS), the entity that insures RBS’s toxic asset book, reported to parliament that under its base case (fairly benign) assumptions, it expected this book to experience losses of £57bn. When RBS produced its year-end 2010 numbers some six months later, we learned that only £32bn of bad debts had been recognised as losses – which in turn reduced capital.

After its controversial £12bn 2008 rights issue, RBS received about £45bn in taxpayer bailout funds, so the difference of £25bn represents about half of the total core capital the bank claimed to have at that time. This concern was properly flagged up by Steve Baker, MP for Wycombe, in May 2011 and a meeting took place at Portcullis House at which RBS’s senior executives’ best defence of this wrong accounting was that they believed other banks were doing the same thing.

The APS accounts revealed for the first time the terrifying scale to which the true financial position of a bank can be distorted by the EU’s accounting regime, the international financial reporting standards (IFRS). Both RBS and the APS prepared IFRS compliant accounts. The difference was that the APS valued the book as an insurer would, valuing the assets using best estimates of what the asset values are after taking account of likely outcomes. RBS meanwhile uses IFRS as a lender, ignoring likely (or even existing) outcomes and only taking provisions against loans that have met the very high hurdle in IFRS for writing down loans, for example several months of missed payments.

2. Marking to model

Under IFRS rules, certain assets (primarily derivatives and heavily structured transactions), for which there is no market, are valued by analogous reference to a synthetic imagined market. The aforementioned Madoff employed this method of accounting.

3. Fair valuing own debt

A healthy banking system is characterised by a market environment in which all major entities strong enough to enjoy the revered accreditation “bank” are believed to be solvent. When confidence in a bank’s solvency drops, the market price of that bank’s debt falls. To wipe out a £1bn operating loss by recording a £2.3bn profit based on the assumption that the bank could repurchase all of its debt at the discounted market price is crazy. RBS did this in 2011 Q3.

If I am wrong, then we have a quick solution to the eurozone crisis, since Greece’s €700bn national debt is trading at half its face value. Greece could therefore declare profits equal to a good chunk of the €440bn fund, which the EFSF have been trying to raise since 19 July 2011.

Leaving aside these concerns about IFRS, what is wholly unacceptable is to allow profit-based bonuses based thereon. To do so is not only deeply unpopular with UK taxpayers but also unlawful.

Distributions, whether of dividends to shareholders or profit-based bonuses to executives, are covered by the 2006 Companies Act, which in theory overrides IFRS for these purposes. Sections 836 and 837 enshrine the importance of “capital maintenance”, outlawing the distribution of profits out of the capital of a bank, for which the last audited accounts are the statutory reference point. EU IFRS has created a situation where complying with IFRS defeats the function required of accounts under the Companies Act.

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