Yesterday in Parliament, I chaired an event with Gordon Kerr, launching his report The Law of Opposites, which is covered in the Guardian today:
Banks use accounting loopholes to inflate their profits and bolster staff bonuses, according to a report published on Wednesday that calls for changes to the international accounting rules.
According to the paper by the Adam Smith Institute, banks are able to use complex financial products such as credit default swaps to report profits that they might not otherwise be able to.
via Banks use accounting loopholes to inflate profits and bolster bonuses | The Guardian. In related news, The Telegraph reports Watchdog’s verdict could put Sir Fred Goodwin in the dock.
As the Adam Smith Institute blogs:
The Adam Smith Institute report is structured around six shortcomings in the rules governing bank profit and capital reporting, which must be addressed:
- Uncertain future cashflows can be recognised as certain by purchasing a credit default swap (CDS) or similar “protection”, even though the supplier of the protection is likely to default if the insured event occurs;
- Profits can be recognised from the increased value of assets, or decreased value of liabilities, on the basis of a market price, even though the totality of revalued assets or liabilities could not be sold at that price;
- Profits can be recognised from the increased value of assets, or decreased value of liabilities, even when the revaluation of assets is estimated, not by market prices, but by a model built by bank employees. This is the so-called mark-to-model approach to valuation;
- The net present value of uncertain future cashflows can be recognised as profits even when they are estimated using implausibly optimistic forecasts. (This is a variation of the mark-to-model problem listed above);
- The EU’s IFRS accounting system, voluntarily adopted by UK and Irish banks at the banking company level, is inconsistent with UK law;
- Banks need not make provision for expected losses when calculating their profit.
The implications of all this are profound, not just for the solvency of banks, but for the justice of taxpayer bailouts and bank bonuses. I’m sure we have not heard the last of the flaws in IFRS and the problems it causes.