Facing up to reality on bad debt could make banks a strong investment once again

Regulator is forcing banks to recognise immediately losses not yet disclosed to shareholders

Financial regulator Matthew Elderfield  at the mortgage arrears plan announcement earlier this month. The plan sets out a strategy for the Irish banking sector to deal with mortgage holders in financial difficulty. Photograph: Brenda Fitzsimons

Financial regulator Matthew Elderfield at the mortgage arrears plan announcement earlier this month. The plan sets out a strategy for the Irish banking sector to deal with mortgage holders in financial difficulty. Photograph: Brenda Fitzsimons


The recent initiative on Ireland’s mortgage crisis announced by the Central Bank’s Matthew Elderfield may help bank share prices in the long run.

Mr Elderfield is forcing banks to recognise immediately losses that banks have not yet disclosed to shareholders.

It may raise a few eyebrows to reveal that banking (including Irish banking) is potentially profitable for two reasons. Firstly, the brand name is strong.

Irish customers may feel sickened when they hear the names Allied Irish Banks or Bank of Ireland, yet, out of convenience and perhaps tradition, they will continue to open bank accounts with them, buy financial products and, where possible, borrow from them.

Low borrowing rates
The second reason is that, unlike any other Irish business, banks are able to borrow at extremely low rates of interest from central banks and often lend that money to the governments at much higher rates.

Even supposedly profitable banks such as Barclays borrow at subsidised rates from the European Central Bank something banks have “gratefully acknowledged”.

The reason banks are in difficulty, and why Elderfield’s announcement will help Irish shareholders, is that banks are dysfunctional and badly run.

Elderfield is simply forcing banks to do now what the Office of the Director of Corporate Enforcement (ODCE) should have told banks to do seven years ago – comply with company law.

Imagine a bank issues a mortgage of €500,000 to a customer who can only afford one worth €350,000. The value of the property has since fallen from €500,000 to €220,000.

Under the Central Bank’s initiative, the banks must negotiate a settlement or recognise substantial losses.

Suppose the customer agrees €370,000 – it stretches his resources but is not unrealistic. The bank benefits by €20,000. However, it is unwilling to negotiate as this would mean recognising a loss of €130,000 instantly.

This is because banks are ignoring company law by carrying the mortgage in their books at €500,000 and not what it is worth – ie €350,000.

Elderfield has warned banks that they must show the mortgage at the value of the property – €220,000 – and recognise a loss of €280,000.

However, if the bank negotiates with the customer a higher figure (in this case €370,000), it need only recognise a loss of €130,000.

By removing the ability to hide losses, Elderfield has discouraged banks from delaying negotiation.

An important question is why shareholders did not force banks to adopt this sensible approach when the crisis first emerged? The answer is down to Fianna Fáil’s Micheál Martin.

In February 2005, as minister for enterprise, trade and employment, he signed statutory instrument 116 of 2005 which, according to bankers, relaxed company law requirements.

Banks subsequently dropped a Statement of Recommended Practice issued by the British Bankers’ Association. That statement forced bankers to tell shareholders immediately of losses on troubled loans.

Its removal allowed Irish banks to delay revealing losses. The statement, if allowed to continue, would have exposed much earlier the reckless lending to property developers and might have saved shareholders, including those that took up rights issues that some banks offered while sitting on a mountain of losses.

Delay and pretend
By removing the “delay and pretend” approach to losses, bankers would have found negotiation with the customer more attractive.

Elderfield’s announcement is therefore nothing more than a return to the days when the statement of recommended practices was used.

Legal experts say that this statement should never have been abolished. The fault therefore lies not with Martin; it is simply that bankers have interpreted SI 116 of 2005 in a way that suits themselves.

Although the EU regulation has some defects, it stops banks from overvaluing assets in the way Irish banks have, according to at least two legal opinions.

If Elderfield’s announcement is taken seriously by the bank, fraternity banks will move closer towards company law once again.

The Irish Central Bank is really doing what the ODCE failed to do, which is to make sure that shareholders see immediately, the damage from reckless lending.

In the UK, the Bank of England issued a damning report into how British banks have similar problems. Like their Irish equivalents, British banks are badly run. The Bank of England warned that not revealing losses “may be a factor explaining banks’ low market valuations and may impair their ability to raise capital”.

Though very risky, Irish banks could be a good long-term investment if company law is restored.

At the present time, banking directors are keen to conceal how much trouble they are in and are therefore mismanaging their loans.

It may well be that Elderfield’s efforts will reveal a worrying mountain of huge losses and cause more pain to innocent shareholders.

At some point, however, banks will turn a corner and become profitable because of their strong brand names and Central Bank subsidies. That corner is getting nearer.

Cormac Butler is the author of Accounting for Financial Instruments and has led training seminars for bank regulators and investors on financial risk. He has traded equities and option s