Unanswered questions on how banks ‘hid’ their losses

It is increasingly likely that we will never really get to the bottom of all this, as the temptation to run away into the post-bailout future grows daily

Pay attention everyone. This column is going to be about accountancy. But it is important, so try to stay with us.

Most of you are by now broadly aware that banks "hid" the losses they were making on property lending for years. Eventually investors and depositors put two and two together – crashing property market and no credit – and voted with their feet. The banks then "owned up" to their losses and had to be rescued by the taxpayer – primarily through the setting up of the National Asset Management Agency.

How and why the banks “hid” their losses is less well known. The why is in fact fairly obvious – turkeys don’t vote for Christmas, particularly rational ones. The how is pretty technical. But it comes down to one question: how did these banks pass their annual audit, an independent examination of their books usually carried out by one of the big accountancy firms?


'Only obeying orders' defence
The explanation has something of the "we were only obeying orders" defence about it. Under the accountancy rules then in place, a bank could only recognise a loss on a loan if the borrower actually defaulted.

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It did not matter if they knew for a fact that the borrower was bust. They still had to treat the loan as “performing” as long as he met the repayments . In many cases, of course, there were no repayments as the loans rolled up the interest and the capital.

Two questions remain unanswered. The first is whether this has been remedied and the second is how it came about in the first place.

The answer to the first question is probably yes. The accounting rules in question are being rewritten, though it is a long-drawn-out process that has to be co-ordinated across regulatory bodies and other interested parties. In the interim, banks and others are disclosing far more information about bad debts to win back the confidence of investors.

The question of how this catastrophic misstep was taken and who is to blame is far more vexed. The collective enthusiasm of the profession to “move on” from the events of 2008 is understandable. There is little to be gained and potentially much to be lost if the writs start to fly.

As a result, the pursuit of the answer to this far-from-academic question is left to activist investor types and parliamentary committees. They face two problems when it comes to broadening the battlefield and generating the interest of the public in something that is without a doubt in the public interest. Understanding the complex interplay between company law in numerous jurisdictions and the international accounting rules is no mean feat. Rendering it into everyday English verges on the impossible.

You then have to identify and explain at which point the profession seems to have abandoned common sense in favour of rules that allowed the non-reporting of losses. Finally, you have to establish who made the decisions and drove the process that resulted in the rules being changed.

And above all this, you have to avoid sounding like a conspiracy theorist . That bit is harder than you might imagine as the usual suspects – investment bankers, overpaid advisers and bank executives – seem to have been the only winners.


Temptation
It is increasingly likely that we will never really get to the bottom of all this, as the temptation to run away into the post-bailout future grows daily. The Government – representative of the taxpayers who were the biggest losers – seems keen to tick the "fixed" box and move on.

A Bill to amend the Companies Act is making its way through the final stages of the legislative process, starting its second stage in the Seanad last week. It implements an EU recommendation and will transfer responsibility for ensuring the quality and independence of audits from the various accountancy bodies to the Irish Auditing and Accounting Supervisory Authority (IAASA).

It should address the concerns of those who fear that the accountancy bodies were not sufficiently independent of their members, in particular the big four firms, which, in turn, were under pressure from their clients to go gently.

But it won’t do much for those who believe something far more fundamental was amiss. This is because the IAASA is the Irish leg of the multinational accountancy rule-setting framework that seems to have got it all so wrong in the first place.