Taxpayers paying dearly as banks conceal loan losses

The International Monetary Fund's Global Financial Stability Report , published this month, has raised fresh concerns about the EU banking system. Non-performing loans in Europe, at €800 billion, have doubled since 2009.

The IMF highlighted the government subsidies given to banks worldwide by dint of low-cost loans from central banks. It says “the subsidy went down from its peak and is now back to its pre-crisis level, except perhaps for the euro area”.

Europe’s largest and most powerful banks receive up to $400 billion (€290 billion) in subsidies. This compared to just $70 billion in the US where banks have been able to reaccess market funding to a much greater extent.

The difference in the level of subsidies reflects the much higher level of confidence enjoyed by US banks who, by and large, have disclosed the extent of their problem loans.

European bank balance sheets remain clouded in uncertainty as a result of continued adherence to rules that militate against disclosure. Interestingly, European Central Bank head Mario Draghi and his predecessor, Jean Claude Trichet, were involved in drafting these rules.

In 2006, both were advisers to a partly EU funded but private organisation known as the International Accounting Standards Board (IASB) – the architects behind the accounting rules that determine how European banks account for non-performing loans. Their central principle is that a loan cannot be classed as non-preforming unless the borrower has defaulted on it. The intention was to stop banks manipulating bad debt provisions to smooth profits.

The flaw in the rule became apparent from 2007 onwards when banks failed to disclose billions of euro worth of loans that were clearly not going to be repaid because a technical default had not yet occurred. Despite this, the IASB has continued to advise the EU not to force banks to reveal losses, arguing that “enthusiasm for greater transparency in accounting is greatly tempered by the possibility of this leading to further bank bailouts!”.

Bad loan transparency
In contrast, the US Financial Accounting Standards Board, though initially allowing banks to delay telling shareholders about losses, have suggested rule changes. US banks are being encouraged to reveal losses. This has increased US investor confidence, with some banks returning to profitability and resuming dividends. It may explain why US banks are largely trusted by investors and not over-reliant on subsidies like European banks.

The US has found a simple way to turn a troubled non-performing loan into a normal loan. Identify what the borrower can afford to repay and compare that to what he currently owes and treat the difference as an instant loss. Once completed, the US Fed can identify which banks it wishes to save and meet the capital shortfall through subsidies and investors.

The ECB has taken a very different approach. It has subsidised banks without requiring them to reveal the losses they have suffered.

The Bank of England has been quite vocal. Banks are tempted to roll over troubled loans to weak firms rather than engage in fresh lending – a process known as "evergreening". It allows the bank directors to put their own self-interest first by delaying recognition of losses until they retire. The Irish mortgage crisis is another symptom. Despite appeals from the Irish Central Bank and the Oireachtas, Irish bankers delay recognising losses rather than negotiate with customers and reveal losses instantly.

The problem is compounded by doubts over the legality of IASB standards. Although the IASB told banks they could in effect delay reporting losses, the official EU-approved wording does not allow this, it is claimed. Attempts by the IASB to resolve the apparent conflict in 2010 by dropping the word “prudence” failed. Recently, the IASB accepted its loan accounting standard was flawed.

Many Irish accountants believe the issue is academic and IASB rules on showing losses did not cause the non-performing loan crisis. They are correct, reckless banking practices are to blame. But if these bankers knew auditors would force them to reveal the losses from reckless lending, they would have been more careful. As the IMF figures show, the problem is far from academic. The failure of Europe to force banks to disclose losses is costing taxpayers millions in subsidies.