Bad loans were legally hidden as Lenihan made pledge

 

ON JANUARY 1st 2005 the European Union imposed accounting rules on Irish banks containing a significant but simple flaw that had an impact on the fatal decision by the Irish government in 2008 to give Irish banks a blanket guarantee.

The flaw allowed banks to conceal substantial losses on troubled loans. It reversed the pre-2005 rules under which banks were forced to recognise immediately, losses on bad lending.

From 2005 onwards banks were required to wait until the borrower admitted difficulty before recognising the loss. Often the gap between when the problem first arose and the borrower’s admission ran into years, making the bad loan figures in banks’ annual audited accounts potentially misleading.

Most people were unaware of the flaw, including perhaps Brian Lenihan when he reached the decision to effectively assume the losses of Irish banks based on, among other things, the bad loan figures in their accounts.

One piece of work in particular that was relied upon by the authorities was the independent assessment of the banks losses by PricewaterhouseCoopers in 2008.

PwC declined to comment for this article for reasons of client confidentiality so it remains an open question as to whether the government took a catastrophic mis-step because it relied on figures prepared under flawed accounting rules.

PwC did emphasise the limitations of its report and challenged Anglo’s own assumptions. Lenihan also had a number of other advisors apart from PwC.

But, the public version of PwC’s report on Anglo Irish Bank suggests PwC placed a lot of emphasis on accounting figures and less on the economics of the transactions – the information, however, is too limited to draw conclusions on.

The events of September 2008 do, however, draw attention to the wider issue of whether bank auditors had an obligation to warn regulators and the government about the potential anomaly created by the 2005 rule change.

The architects behind the EU rules, the International Accounting Standards Board, gave an assurance in 2008 the flaw didn’t exist. The then head of the IASB advised that banks were never allowed to conceal losses on troubled loans.

However, an inquiry by the British House of Lords last year on bank auditors has concluded otherwise.

A related issue is whether all the Irish bank auditors had a duty to tell Irish regulators, who over-relied on published accounts, that banks were potentially not recognising all losses.

The answer to some of these questions centres around whether Irish auditors and banks can rely on the argument that mechanical compliance with the IASB rules is alone sufficient to comply with Irish company law.

Legal opinion suggests it is not. Martin Moore QC has advised that auditors cannot ignore the company law requirement to recognise losses even if the IASB permits it. In fact, Moore says the EU should not endorse any accounting standard that is contrary to EU Articles. These articles are similar to Irish company law.

Central Bank governor Patrick Honohan has in the past publicly criticised the IASB rules and scarcely contained his anger at banks not recognising losses.

Recently, the Irish Central Bank has asked for additional information on troubled loans. Like their British counterparts, Irish regulators are beginning to ignore published accounts.

Commenting on the EU accounting rules, one regulator said: “As with other regulators worldwide, the Central Bank used audited financial statements as a primary tool in its supervision of regulated firms.” Despite receiving “clean” audit reports, they were “under-providing for impairment”.

Pension funds are also on the attack. In December, a report (UK and Irish Banks Capital Losses, published by the Local Authority Pension Fund Forum, see left) examining the €180 billion loss that was amassed by British and Irish banks concludes “not identifying the accounting standard as the root cause of the initial phase of the banking crisis has led to several misdiagnosis”.

In this report Anglo, tops the list for losses relative to size, and it is followed by Allied Irish Bank.

Today, seven years on, the accounting rules are still in place and the IASB seems reluctant to reform them. In the meantime, even bankers are unwilling to lend or trust each other, perhaps knowing that the flaw permits skeletons in the cupboard.


Cormac Butler is the author of Accounting for Financial Instruments, published by Wiley