Concerns about the implementation of the Basel Accord raise the hackles of the Bank of England

Tension is developing between the European Union and the Bank of England on the regulation of banks which may dominate headlines in 2013. If the dispute moves as expected, a solution to Ireland’s legacy debt problem could evolve.

At issue is a set of rules known as the Basel Accord, designed to make banks safer by restricting how much they are permitted to borrow to fund their assets. The banks’ concern centres on whether the rules will work if company law is ignored.

Suppose a bank has lent €100 billion in mortgages to customers. The Basel rules restricts to about 96 per cent the assets that should be financed by liabilities such as customer deposits. The remainder, 4 per cent, must come from shareholders. The 4 per cent is designed to shield customer deposits from mortgage holders who default. Under revised rules known as Basel III, that figure will double to 8 per cent, offering even more protection.

The Bank of England’s Financial Stability Report published in November makes the important but obvious point, however, that if a bank’s published accounts conceal losses by overvaluing assets – a practice still permitted by the EU – attracting shareholders is impossible.

Any money shareholders invest could end up financing Ponzi-type schemes where the money raised is used to pay off existing losses.

The report reaffirms that shareholder confidence in banks remains low. It also claims that even before the banking crisis, British banks were concealing £50 billion in losses.

Finding shareholders is only one of the many problems the EU faces; the report identifies other flaws. Ironically, the Basel Accord fails to distinguish solvent from insolvent banks.

Poles apart

Imagine there are two banks, each with assets of €100 billion and €94 billion in customer deposits. Bank A lends recklessly and regulators believe that the assets are overvalued by about €40 billion. Bank B, on the other hand, is well run and seeks collateral, as well as watertight documentation, before it advances money.

Under EU rules, Bank A is not allowed to tell shareholders of its losses on reckless lending. The result is that both banks, although poles apart, are treated the same under Basel II, despite the fact that one is definitely insolvent and bankrupt and the other is not.

This problem arises because the EU has not yet forced banks to recognise losses on troubled loans. The Bank of England report has expressed its strong irritation that the matter remains uncorrected. It recommends that regulators must identify losses before applying the Basel rules.

A third problem recognised by the Bank of England is “evergreening”, a term used to describe how banks must operate dysfunctionally when flawed regulation is used. Put simply, banks are tempted to make fresh loans to existing troubled customers rather than healthier new customer because it delays the need for troubled customers to admit they are in difficulty.

Brendan McDonagh, of the National Asset Management Agency, discovered Irish bankers were advancing new loans to existing troubled customers so that they could meet obligations on old loans. Ireland has recently set up the Credit Review Office to encourage bankers to make genuine loans.

In 2005, the EU endorsed a set of rules – International Financial Reporting Standards (IFRS) – that compelled certain banks (particularly in Ireland and Britain) to conceal losses on certain troubled loans until they are realised, a first in the history of company law whose rules are generally designed to protect shareholders.

A legal opinion from Martin Moore QC argues that the EU may not have had authority to do this. The architects behind the controversial rules admit they were overly complicated, rushed together in an “inelegant” manner and are not fully understood by anyone.

Hedge funds seem to have realised this, the Irish public has not, and this may explain why the EU is anxious to protect bank creditors but burdening the Irish taxpayer in the process.

Bonus-hungry bankers, however, have backed the EU rules. This is understandable, given that since 2005 they were able to inflate profits and bonuses which were paid even while bankrupt – something that wasn’t possible before.

A Bank of England executive claims banks have ignored the “true and fair” requirement of company law because of unrecognised losses and this month predicted that bonuses and gold-plated salaries of bankers would fall dramatically.

A consortium of major pension funds in the UK has started to lobby strongly to reverse the controversial EU rules in line with what the Bank of England recommends. It has written to commissioner Michel Barnier warning that the process by which the EU endorsed the concealment of losses is contrary to EU company law and opposes what the EU agreed when countries such as Ireland signed up the amendments into national legislation.

Concealment of losses

The consortium has issued two position papers, one on the accounting rules which permit the concealment of losses and a second on reforms needed in the audit industry. The consortium is taking a keen interest in Ireland’s presidency of the EU this year, hoping to win the backing of Irish politicians in its campaign.

This week, it was reported in the Daily Telegraph that the office of commissioner Barnier has agreed to a review.

If the Bank of England’s recommendations are adopted, the EU may have to admit that its contribution to the Irish banking crisis is a little more than first imagined.

In 2008, Brian Lenihan received advice that Irish banks were solvent. Like shareholders and regulators, Lenihan was most probably not aware that the report reassuring him on this point legitimately concealed losses, exploiting loopholes that the EU created. For different reasons, the UK’s Bank of England wants to resolve this urgently.

Cormac Butler was a contributor to Lessons for the Irish Government on Basel II and Accounting Failures, Vol 6, 11-14, Journal of Risk Management in Financial Institutions, Henry Stewart Publications