Friday, January 23, 2009


Many people might imagine that banks accounts are today not unlike one of the Circles of Hell in Dante's Inferno or Heironymus Bosch's painting of Hell (painting detail above) that awaits all sinners who do not look up and who discount the all-seeing Owl (symbol of Christ and high moral view, as in painting detail later below). We expact the accountants and AIBD and FASB accounting standards to be the owls of public companies' accounts, and most especially of financial services where cash flows are highly leveraged and subject to fast moving market prices (and also by ratings agencies' risk grade models), but that is what we expect of them. There are different cultural attitudes to accounts. In the UK, business is dominated by accountants and therefore by corporate governance based on information in the statement of accounts. In the USA, where business is dominated more by lawyers, corporate governance focuses more on what is done and said in the markets. This kind of distinction may be alternative views of 'agency theory' and goes to the heart of issues that are being raised in the courts by aggrieved shareholders whether in Small Claims Courts or in massive 'class actions' in the higher law courts. The relationship between management and existing shareholders that has become strained past breaking point for credit crunched banks is the classic principal/agent problem. Management, the agent, has 'free' scope for action, but shareholders must monitor that 'freedom', using the information in financial reports. This is why financial accounts are presented at shareholders company meetings, and why at this time especially the authorities must be especially vigilent regarding 'market abuse'. It is the shareholders' forum to question and vote on the performance of management, where financial reporting is involved in determining future cash flows, not merely predicting them. A popular term for the process of monitoring management is corporate governance that depends on company laws and accounting standards. It is bizarre therefore to see directors of banks advising shareholders on the basis of assurances (such as about liquidity risk problems, takeovers and mergers) without reference to financial statements, in effect rejecting the relevance of detailed financial reporting to corporate governance. Reasons for this include the lack (before IFRS7 and Basel II standards) of forecast scenarios, the difficulties of 'fair value' pricing in 'turbulent' markets, and different origins and forms of the U.K. and U.S. regulatory systems for financial reporting. These two cultures conflict within Anglo-saxon banking and in the accounting standards and regulation laws. I experienced this very recently in the HBOS takeover by Lloyds TSB case when it came to be approved by Edinburgh Court of Session where I (with Ian Fraser, intervened as petitioners and in the interest of future law questioned the 'Scheme of Arrangement' regarding what we saw as 'Market Abuse' and negligent and misleading information by management. The UK system's culture is based on company law, whereas the USA's is based on market regulation (the Securities Acts). The latter emphasises belief in the accuracy of markets and their prices for information relevant to future cash
flows, whereas the former lays greater trust in corporate governance. The FASB’s Conceptual Framework reflects U.S. institutional culture and favours the market view. In the EU, where in most member states business is less dominated by publicly quoted companies, the legal tradition and accounting regulation strongly favours the company law approach and on corporate governance mechanisms, including as in the UK, the idea of management as 'stewardship'. Auditors have to venture into the burning books like NYC Firemen into the towering infernos with miner's lamps and fireproof jackets. The light from the lamps is one thing, fire=proof jackets is another. It is that latter aspect that motivated LAST WEEK THE MAJOR ACCOUNTING FIRMS TO ANNOUNCE THE PROBABILITY THEY WOULD HAVE TO QUALIFY ALL BANKS' ACCOUNTS NEXT YEAR! AND THIS THREATENS THE BANKS IN VARIOUS WAYS NOT LEAST THEIR CREDIT RISK GRADES! The problem is really that the banks have not got their approaches and systems organised to truly analyse with scenario modeling their Economic Risk Capital Models as required under both CRD (Basel II) regulations and IFRS7 (the new accounting standard mandatory in 2009 that require stress-test scenarios and forecasts of exposures). Hence, the problem, from the accountancy firms viewpoint, includes the banks' inability, especially in the current financial panic and recession, to fully deploy IFRS7. This does not mean that the banks' accounts will be qualified for showing too little credit loss and asset writedowns. They may also be qualified for showing too much loss when IFRS7 allows more 'stochastic' realism to value assets at fair value over a longer time period. The FSA is in talks with top auditors to try to ensure banks are not destabilised by accountants making a qualified judgement in annual accounts on their capacity to continue as a going concern. The talks come amid fears that auditors could qualify accounts of big banks because of uncertainties around their funding and dependence on government money.
As important, or more important, are the risk grading agencies who grade the assets of the banks and the banks themselves according to the banks published accounts. While the banks may be adequately covered in their assets (loans) by security and collateral and, as anyone would agree, also secured by Government insurance, guarantees, shareholding or funding either actually committed or available such as from The Bank of England, these solvency supports are not taken into account by the ratings agencies models. There is a danger of the ratings agencies downgrading banks to below unsecured borrowing status, which could be as fatal as it could be ludicrous! The FSAy has met twice at least with the top six accounting firms to discuss key issues, including how it can help to avoid any problems with the auditor opinions. Most banks are busy trying to finalise year-end reports. These are much harder to fairly calculate given shareholder financial panic and the credit crunch turmoil plus worsening recession fears. This makes many assets hard to price, and the banks’ net cash-flows harder to predict when there are many non-cash flow items that can impact profit & loss totals. A bank that is quite sound in its net trading profit may nonetheless look insolvent when 'paper losses' are subtracted. A clean audit opinion means auditors consider the accounts to be fair and that the company is viable for a year from the date of sign off. At worst, companies can receive a “qualified” or adverse opinion, meaning auditors have serious qualms or an unresolved disagreement or simply cannot agree a single firm price and might have to consider reporting a range of values and a range for P/L. This would be deemed very unsatisfactory. Accounts should be definite, not a probability of somewhere between A and D.
A qualified opinion is extremely rare and never likely as it could prove disastrous. Auditors told the FSA that any issues that severe must be resolved before accounts are published. But, even then, banks and other financial institutions may receive embarrassing footnotes to the accounts or some kind of “added emphases” i.e. paragraphs in the audit opinion designed to draw attention to key disclosures, but stopping well short of a full 'qualification of accounts'. The problem for the banks is like a trapeze artist's, how to spring safely from one old accounting and banking culture to a newer risk=based culture and to do so across the chasm of credit crunch and recession. Governments sensibly recognise the problem and have strung out the safety net, but cannot be sure if it will hold. They know that logically it will. But, for that to succeed the general public, taxpayers and also shareholders have to believe, see the logic and calm down, stop panicking. This is not easy when there are doomsters and short selling hedge funds and others with an interest in maintaining the panic so they can profit from it. Stocks continue to be loaned to avaracious short-sellers who short banks, knowing full well how to push the prices down using very small sell orders, and pulling down other companies' share prices too. The FSA under pressure from possible law suits by hedge funds - absurd - caved in and lifted the ban on naked short-selling. The ban was absurd anyway; far too ineffectual and not geared to reality with only a 0.25 % of stock short position next day reporting threshold. Bu, then short-selling bans are innefectual unless internationally applied. The effective solution is to ban stock lending if only for a year or too, gaining time thereby for new checks and balances. But banning stock-lending has never even been considered or broached outside of the media.
The now rather lame-duck FSA confirmed it had met with the auditors as part of its supervision of the banks. Auditors are not concerned with systemic problems affecting the whole finance sector. neither is the FSA (this being the responsibility of the Bank of England). The FSA is concerned about solvency of each bank or other financial institution. Auditors are both concerned about systemic failures in a bank's accounting system, such as an unexplained mismatch between two sides of double-entry book-keeping (the general ledger), just as FSA is concerned about mismatches between risk accounting and regular accounting (the calculation of regulatory and economic capital).
IFRS7 bridges between these two perspectives. It introduces risk accounting more fully into regular accounting to align better with the CRD. And in essence this requires banks to align their pricing and performance with their understanding of the underlying financial markets and general economic conditions. This is very hard for them to do well. They mostly do not know how to do this succinctly and globally! It is an immense intellectual challenge. Intellectual challenges cannot be met by organisation with a dysfunctional silo mentality i.e. when banking groups are really a conglomerate of separately run businesses with their own discrete profit centres and financing that can make light of or duck oiut from under group-wide capital risk concerns. Sometimes this is because the subsidiary businesses are separate licenses or have fiduciary duties to honour that do not fit with the crisis that group management finds. Good examples of this include trustee management of customers' life, insurance and investment funds, and company pension funding gaps, structured products, and in retail banking (for households and SMEs) the powerful advice of Government to maintain lending levels. A further factor getting in the way of everything is the bonus culture, which is frankly current in a systematic mess, but cannot be done away with. Bonuses are like football star fees, minimally conditional on sensible goals such as winning the cup or avoiding relegation or gaining league promotion. the reason is that fees are dictated less by fundamentals than by market competition. Investment banking in certain areas remains a people relationship business. Pay the bonus or lose the team? I expect that the FSA may have hinted to auditors that they want to see some auditing of bonuses in the annual accounts. What are the models, the algorithms and the justifications? But, before auditors can even begin to go there they have to determine what the bank's performance really is. And that is already looking far to difficult and avoid qualifying the accounts! Meetings of auditors and the FSA began in December. Auditors told the FSA they needed extra information from the Bank of England about its so-called discount window facility. This concerns confirming the individual drawing rights of the banks. For example, does HBOS have a liquidity problem if it has a £38bn draw-down available? The conditions attaching to assets that my be swapped at the SLS change, and the drawing rights are discretionary, not fixed. Therefore how can auditors rely on this funding resource as a definite security supporting the solvency of the banks. This is not trivial when the bulk of interbank liquidity funding is occurring via the central's bank's SLS window, which has turnover rolling dates and is necessarily short term (less than 1 year) to ensure the debt is off the books of the National Debt? Some newspapers reported this issue was largely cleared up in the measures announced on Monday when the Bank of England said it was extending the window, where banks can ease liquidity problems by swapping assets for government bills, from a one-month rollover limit to a full year. But, actually that was always understood to be the reality. It is merely now formally confirmed, which is helpful.
The big accounting firms are international. It would be egregious if they qualified UK banks' accounts and failed to dos so when auditing similar situations in foreign banks either in UK or abroad. Half of all banking assets in the EU are managed in the UK by UK banks and by branches of foreign banks. Any upsetting of a level playing field, moving or narrowing to goalposts at one end, and the game and distribution of banking business will change dramatically. More on these vitally important matters to come.

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