Steve Baker, the MP whom we here actually rather like, has a piece in the latest Jewish Chronicle, which makes what seems to me like a very important point. I have this point alluded to vaguely, but never spelled out. It is that the outrageous behaviour of the merchant banking fraternity in recent years is as much a product of bad bank regulations as it is of mere capitalistic greed.
It being the Jewish Chronicle he’s contributing to, Baker alludes to some scales that are criticised at the beginning of the Book of Proverbs, Chapter 11 (which American readers may consider rather appropriate, what with the times we (and they) are now living in).
The particular rules that Baker zeroes in on are the accounting rules that define profit:
Among other problems, IFRS accounting rules incentivise trading in derivatives by enabling unrealised, perhaps fake, profits to be booked up-front, leading to large but unjustified bonuses and dividends. They grossly inflate profits and capital and discourage banks from making prudent provision for expected loan losses. They also discard the time-honoured principle of prudence embodied in UK company law. In doing so, IFRS gravely weakens the audit function and the vital check it imposes on bank management. This undermines effective corporate governance in banking. The upshot is that IFRS makes bank accounts highly unreliable; no-one has a true view of our banks’ financial strength. All this contributed greatly to the financial collapse. IFRS made banks appear more profitable than they were. This led them to imprudent expansion, to payments of bonuses they could ill afford to make and to inadequate provisioning for likely losses.
I am not qualified to second guess Baker on this. But I do know, as a general principle, that when one observes something going wrong with the world, one should not immediately assume that yet more laws and regulations are needed to curb whatever it may be. Rather, one should ask what laws or regulations – laws or regulations already in place – are causing or at the very least greatly exacerbating the problem in question, and should accordingly be got rid of.
Baker makes a fine point but manages to avoid mentioning that it is the EU who insist on the use of IFRS.
I wonder if this is where Gordon went wrong managing the finances of the State – along the lines of enabling unrealised, perhaps fake, revenues to be booked up-front, leading to large but unjustified spending.
Good article. Accounting standards may make folks’ eyes glaze over, but they have played a considerable role in the recent mess, arguably even greater than debt rating agencies. What is known as “mark to market” accounting – where a firm’s assets are updated daily in line with market movements – replaced the older forms of accounting for a firm’s assets. (Older methods tended to smoothe out fluctuations). The result of this mark-to-market accounting was a massive volatility on a firm’s profit and loss account.
The trouble with this finance geekery is that it does not get the public’s juices flowing, so naturally, it is far easier to rant about bankers’ pay, or “fatcats” or some other knee-jerk rubbish.
Steve Baker is to be congratulated for not playing to the gallery and focusing on this sort of detail instead.
The link takes one to the Chapter 11 Bankruptcy procedure in the USA. I think Proverbs 11 was intended by the author:
http://www.biblegateway.com/passage/?search=Proverbs+11&version=NKJV
Dishonest scales are an abomination to the LORD,
But a just weight is His delight.
2 When pride comes, then comes shame;
But with the humble is wisdom.
3 The integrity of the upright will guide them,
But the perversity of the unfaithful will destroy them.
4 Riches do not profit in the day of wrath,
But righteousness delivers from death.
First an anecdote (true):
We had finished an excutive committee meeting for a very large holding (financial) company in Dallas for which I was outside legal counsel to one of the major specialized sectors of operations, walking outside with the Chief Accountant of that sector (it had no CFO) who had just been repeatedly pressed on various factors that would ultimately add a penny or so to the parent’s reported earnings,he said: “Counselor, I think I now understand that there is a difference between reporting earnings and making money.”
A few years before, that unique analyst Ted O’Glove had coined the phrase “Quality of Earnings,” which I had to defend before him when the S.E.C. began applying GAAP to insurors to replace statutory reporting (the latter focusing on financial strength rather than earnings).
It all began years ago!
I have no problem with mark to market accounting. Its preferable to smoothing out returns. As far as derivatives are concerned, most derivative contracts require daily collateralisation of mark to market positions, so there is no question of the earnings being fake. There was a problem with many CDO’s and asset backed securities (these are not derivatives) being ‘marked to model’, where the values were only estimates. This could then be used towards capital requirements (subject to haircuts) and increased leverage.
There is of course a problem of short term accounting profits that are real, in the sense that I have described, but do not reflect improved cashflows. This does (and did) encourage short termist actions. I think a much bigger contributor to the financial meltdown was limited liability and hence limited responsibility (witness Fred Goodwin) and also of course the fiat money system.
It is definitely true that regulations spawn methods of getting around them. There is for example some new EU regulations that will require a central counterparty to be used to clear certain derivatives. This will require counterparties to have much more cash to hand than they used to. This has already led to a preference for derivatives that are not included in the EU regulation.
I do have a problem with “mark to market” accounting. I understand the rationale and, to some extent, sympathize with the objective, but in my opinion it’s far more conducive to manipulating earnings and financial condition than the old-fashioned “historical cost” method. At the very most m-t-m should only be used with assets held for sale (i.e., not long-term investments) and where there truly is a liquid market so the value can be objectively ascertained. If you have to hire a consultant or run a computer model to figure the value (as opposed to simply looking it up on your Bloomberg screen) it’s not an appropriate asset for m-t-m treatment.
As the events of the last few years proved, m-t-m absolutely failed in a collapsing market, and the regulators were forced (grudgingly, belatedly, without acknowledgement of error, and only partially) to back off from it when everything hit the fan. It’s one of those ideas which looks wonderful up in the ivory tower but fails miserably in actual practice.
Martin Cole
The links, plural, are exactly as intended.