Bank loan loss problem has not gone away

The extent of the Irish bank's losses and the question as to whether they are still concealing them continues to crop up and is unlikely to go away in 2014. European Central Bank president Mario Draghi warned in mid-December that Irish banks have to make "adjustments for provisions", hinting that more undisclosed loss may exist.

Interestingly his predecessor, Jean Claude Trichet, may have played a bigger part in the creation of this problem – and the wider crisis – than many realise.

In 2002, well before the banking crisis started, the Federation Bancaire Français, which represents 430 French banks, warned the ECB in a document titled Loss of Confidence in the Financial Markets and International Accounting Standards that proposed changes to international accounting rules contained "serious deficiencies" that enabled banks to hide losses and record artificial profits.

Catastrophic error
In 2004, Trichet wrote to the International Accounting Standards Board (IASB), which sets accounting standards, noting that there were problems. The IASB, however, ignored their critics and rolled out the controversial rules under which banks did not have to make provision for loans as long as they were meeting the terms of the loan agreement, regardless of what other information the bank might have access to about the borrower or the economy.

Both Ireland and Britain adopted them in full. France, on the other hand, ignored the IASB rules on loan losses. America adopted similar rules to the IASB but, following the banking crisis there, it forced banks to be a lot more transparent on their losses.

In early 2009, when the crisis was at a peak, a Leaders of the G20 summit in London called on the ECB and other regulators to address urgently how the IASB accounted for losses.

Seven months previously, the Irish Government had relied on a due diligence report which used the IASB rules to give the impression that Irish banks were healthy. Unlike Trichet and the ECB, in September 2008 Lenihan was most likely unaware of the flaw. Two years later, however, both he and Enda Kenny were well aware of the problem. By then, however, most of the damage was done.

The IASB rules remain in force – although banks provide more information. It is an open question as to whether modifying them, or their application, would incentivise a speedy end to the mortgage crisis by forcing them to engage immediately with their customers and face reality.

The question as to how and why this catastrophic error was made in the first place also remains unanswered.

During 2013, two inquiries examined the way that banks reveal losses. The House of Lords report Changing Banking for Good questioned the process by which the IASB rules were adopted into EU law. It also called for a return to the UK rules that force banks to reveal instantly any losses they have suffered.

Conceal losses
A second inquiry, led by MP Andrew Tyrie, which is ongoing, has questioned how Co-op, the recently failed British bank, managed to conceal £1.5 billion (€1.8 billion) of losses, eventually revealed in February last year despite commissioning a due diligence report designed to identify such losses.

Perhaps the most significant development is two legal opinions that emerged last year – one from George Bompas QC critical of the UK's Financial Reporting Council (FRC). The FRC – whose writ extends to Irish accounting standards – claimed the IASB rules were in compliance with obligations under UK company law to disclose losses. Bompas concluded that they were not.

The FRC responded by publishing legal advice from Martin Moore QC. While Moore claims the Bompas opinion was flawed in some areas, he too called on the IASB to restore "prudence" (the requirement to reveal losses) into its framework, acknowledging that the actions of the IASB to remove it was not formally endorsed by the EU, and therefore not legal.

Given the sums of money lost by investors in collapsed banks, it is likely that the issue of blame will ultimately end up before the courts. In the meantime, the issue of transparency around losses – and potential capital calls on the taxpayer – remain.

Patrick Honohan

In a speech last year, Central Bank governor Patrick Honohan

– one of the first central bankers to blow the whistle publicly on the flawed rules – noted: “Although accounting practices are evolving, existing methods typically do not take full account of expected loan losses.

“When expected loan losses are higher than provided for in the accounts, and when uncertainty surrounding future developments is high, banks need more capital if they are to operate effectively in the market without dependence on Government.”