Tim Bush does, in effect ask the above question in his paper on the failings of the IFRS with regard to UK and Irish banking and says:
The Queen asked of the banking crisis “why had no one spotted it coming?” The reason, I submit, is quite simply due to the above. A shared model that had worked in the UK and Ireland since 1879,
was replaced by another shared one that produced false profits, overstated capital, misleading creditors, misleading shareholders, the Bank of England, FSA and others.Although IFRS had been rolled out across the EU, the UK and Ireland implemented it so extensively that the impact was different. It has been a “double dose” to the extent of being a deadly dose, by removing what had underpinned banking solvency for over 120 years. In engineering terms it was like a signalman sending a train down the wrong track. The UK had the first failing bank, Northern Rock, which only the month earlier appeared to have so much capital it applied to reduce it. IFRS merely reports the train crash rather than prevents it.
The banking crisis was systemic in the UK and Ireland, including the building society sector, despite having different currencies, different interest rates and different banking regulators. The common factor was a banking system underpinned by a Company Law Accounting Standards system since 1879, then being replaced by a new one from 2005, with one with severe faults with solvency left out. IFRS implementation cost hundreds of millions in some banks, but the real cost has been many, many multiples of that.
The root of the error is that the ASB is tasked with setting accounting standards for the purpose of the Act (which includes supporting banking solvency) and not merely “financial reporting standards” for the purpose of the EU capital market Transparency Directive from which IFRS came. A crucial difference and a fatal error. Parliament did not change the required output standard of audited accounts of banks (i.e. repealing Sections 830-837), but the ASB’s method of implementing IFRS changed the method of delivery to a sub-standard level.
The essence of Tim’s argument is a simple one and it is that UK company law has since 1879 been committed to ensuring companies are solvent. The current law is to be found in sections 830 to 837 Companies Act 2006 — and auditors have an absolute duty to understand and report on it. Tim argues that under IFRS this obligation was ignored — and worse still, the UK Accounting Standards Board facilitated that process by thinking that compliance with a flawed approach in IFRS was more important than compliance with UK company law. This is, of course, the ultimate arrogance of self regulation.
The issue of greatest importance was the recognition of provisions for bad debts. Under the UK’s accounting standards — and company law in the UK until International Financial Reporting Standards came along — prudence was required. So bad debts were anticipated and provided when reasonable doubt arose. Under IFRS this was outlawed — bad debts were only allowed to be recognised when they had gone bad. So concern was not enough. A disaster had to happen before provision was made — hence Tim’s claim that “IFRS merely reports the train crash rather than prevents it” because capital is knowingly overstated in the meantime — and reported, quite incorrectly as being true and fair.
No wonder banks fell over one after the other.
All of them helped by that other imprudence of IFRS — that a company’s debt can be revalued to market worth — meaning banks could and did take profit on its own gearing before the crash.
And who is responsible for this? The UK accounting profession — without a shadow of a doubt.
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Nice theory, but it doesn’t hold muchwater because all banks run a techinically potentially insolvent position all of the time by borrowing for much shorter terms than they lend. If the auditors took this point to its rational conclusion they would declare all banks insolvent all of the time. They don’t do so because government banking supervisory agencies monitor the liquidity of the bank funding markets and traditionally warn the banks if they think they are over exposed to illquid funding markets. At least that is what the Bank of England used to do but the FSA admitted after the failure of Northern Rock that they didn’t bother because they thought the Bank of England would step in if any UK bank couldn’t fund itself (although they didn’t bother to check the point with the BofE).
A more prosaic reason that so many UK and Irish banks fell over in the banking crisis id that they were all over-exposed to the property market. All the Irish banks had heavy exposures to Irish, UK and European property markets as did NR, B&B, HBOS and RBS and the Dunfermline BS, whereas Barclays, HSBC and Standard Chartered had much less exposure. Abbey/Santander also had a significant amount at risk, but they were always a much more conservative lender than the banks that failed.
@Alex
You utterly miss the point
Is that deliberate?
Well I don’t think for these purposes that the differences between UK GAAP and IAS39/IFRS9 are the root cause of the problem. The minor differences between the treatment of impaired assets held to maturity under IAS, FMV acounting under IAS and the treatment of assets under UK GAAP alone doesn’t explain the strength and severity of the banking crisis. Bear in mind that outside the real estate markets there weren’t many defaults from borrowers.
What there were in abundance was heavily structured investment vehicles that were given very high ratings and ratings sensitive lenders. When the rating agencies started to downgrade certain assets, banks needed to apply more capital at the same time as they saw the market price of their assets fall so the whole system fell in on itself.
The problem wasn’t that the banks assets became worthless merely that they had to apply more capital to the assets on a downgrade and their funders had no idea how much more capital they might require and hence whether the banks might become insolvent. So interbank lending dried up and we had a banking crisis. I don’t see that that is particularly driven by IFRS 9, IAS 39 or anything else to do with loan accounting.
@Alex
I reiterate =- I really do think you entirely misunderstand the paper
I have to confess the argument doesn’t seem to hold water. I am no fan of IFRS, but this criticism seems as misplaced as the complaint often heard from the US Right that it’s all the fault of those nasty fair value rules.
It would certainly be a good thing if the banks were all required to recognise their losses faster – this would potentially shorten the downturn but I don’t see how it would have avoided it.
I understand it perfectly well, but I also understand that with the exception of the Dunfermline Building Society it was not largely the reason behind the banking crisis.
It is a very interesting paper on the defects of IAS39, but despite the author’s comments, most of the banks that the banks were not overstating their profits. Their problems came about when the guarantees thatt were wrapped around a lot of the assets they held were downgraded, their assets fell in value and they could raise their required funding. I don’t think that would have been picked up under a UK GAAP solvency analysis.
Richard – I dont think the change in recognition criterea under IFRS has been that profound. And it was done to avoid creative use of provisioning by companies – in itself a problem in the past.
The use of fair value accounting almost certainly has led to an increase in volitility of the values of banks. We may have to consider whether historic cost wouldnt be better for all but the most commonly exchanged assets.
And lets not forget that risky behavoir, excessive personal rewards, and the ability to book profits on jobs up-front is at the root.
@Alex S
I find it hard to agree
Accounting moved from a position where prudence was central to one where prudence was outlawed
The impact was profound – and catastrophic
The minutiae is the rules
The big picture is the mentality
Look at the big picture and then the impact of such an innocuous change becomes apparent
Tim’s argument just doesn’t seem consistent with the reasons so many banks failed. He’d have more credibility if, rather than talking in generalities, he applied the argument to an actual bank that failed (or came close to failure), and showed the precise role of IFRS in that failure.
If you understand how banks work then you would understand that the way a bank reports its profits will have very little impact on the way it considers risk.
Most banks, or at least all of the banks that I have ever worked for or dealt with, have a financial reporting function that feeds into the FD/CFO’s office who produce the financial results.
There is a very separate reporting line that manages the risks in the business and approves individual deals. They look at the profitability of individual transactions, the associated risks and whether the transactions represent an adequate return on the risk. How the profits are reported is of little importance. The important consideration is whether the bank will recover its investment plus a return on the allocated capital. The quality of the asset portfolio is generally reviewed by the risk management department, internal (and sometimes external) auditors and banking regulators, but the financial control/reporting side of the bank is not involved. It was these people who got the whole securitisation market wrong and passed assets as virtually risk free when they weren’t, but I don’t think there mistakes were driven by poor accounting.
It is also worth remembering that the normal corporate solvency analysis is not necessarily the appropriate test for banks. Bank directors still have the same legal responsibilities, but these are not likely to be an issue if the tighter contraints for banks are applied. The more relevant test for a bank is whether it retains the minimum capital required by their regulating authority, but since the regulators can and do vary that amount and often do so by reference to the quality of the asset portfolio rather than any financial results, the precise accounting may be irrelevant.
For example, a bank may have a property loan portfolio that looks a bit dodgy at time when the whole property market looks as though it is going south, so the regulator will tell them that they have to increase their Tier 1 capital ratio before any losses are reported.