Banking StandardsWritten evidence from Cormac Butler

Introduction

1. For 20 years I have acted as an advisor and consultant on risk management, and have trained over 100 Central Bank regulators around the world. I am a former consultant with Lombard Risk Systems London and have also worked with Peat Marwick and PriceWaterhouseCoopers. I graduated from the University of Limerick, Ireland with a degree in Finance and have published two books on financial risk management (Financial Times) and accounting for financial instruments (Wiley). I have just completed research with a Dublin professor examining the combined effectiveness of the new Basel rules with the International Financial Reporting Standards (IFRS) to be published in November 2012.

Executive Summary

The interaction of banking regulation and accounting rules coupled with short-term bonus incentives continues to permeate the banking sector causing many banks to operate in a dysfunctional manner.

If banks are permitted to conceal losses a situation could easily arise where bankers award themselves bonuses for entering into loss making transactions. I have shown a simplified example in Appendix One how this can happen.

I am concerned that in previous House of Lords enquiries, advice on the legality of hiding losses in this manner was potentially misleading.

Banks continue to use “off balance sheet” structures similar to the type used by Enron and Lehmans. Here too, I believe that House of Lords committees were misled on the use of these structures.

At least two accounting committees are at risk of misinterpreting a legal opinion by Mary Arden QC. They have concluded for instance that banks are permitted to conceal losses from shareholders and regulators if the International Accounting Standards Board (IASB) permits them to do so. Other legal opinions from the same author however make clear that a different conclusion should be reached.

Banks (even supposedly successful banks) find it difficult to raise capital and borrow money despite the extra demands faced upon them by the new Basel rules. This makes them too heavily dependent on Quantitative Easing policies and other initiatives by the UK government. Transferring credit risk from the private sector to the government in this way can only lead to more dysfunctional banking.

The issue isn’t so much that the accounting standards are flawed; banks have survived flawed regulation in the past. Instead the problem is that shareholders and regulators were not aware that banks were allowed to hide losses, particularly between 2005 and 2010 and as a result were unable to take corrective action soon enough. There is still worrying evidence today of investors being reassured that banks are forced to tell shareholders and regulators of all losses.

As with the accounting rules, the regulatory rules on Tier One and Tier Two capital, known as Basel 2 (and now Basel 3) have created a distortion in the way banks lend money. I have illustrated this in Appendix Two.

Responses to the Committee’s Questions

To what extent are professional standards in UK banking absent or defective? How does this compare to (a) other leading markets (b) other professions and (c) the historic experience of the UK and its place in global markets?

The banking sector has suffered from a type of ‘regulatory capture’ whereby bankers developed complex structured products that appeared to be profitable but were in fact loss making and very difficult to understand. Through these structured products banks were able to exploit the lack of resources available to regulators by concealing risks and hidden losses and awarding themselves bonuses for artificial profits. This indicates a lapse of professional standards.

In 2005 retail banking was affected by company law rule changes that potentially permitted banks to conceal losses on straightforward retail and corporate loans. As a result, destructive lending practices like the ‘125%’ mortgage emerged. Accountants should have seen this and warned shareholders to take action quickly. Their failure to do so is another potential lapse of professional standards. However, the EU rules that permitted this were applied differently in the UK and Ireland compared to the rest of Europe.

Internally bank risk management divisions suffered since banks were reluctant to measure hidden losses and leverage as this would have a negative impact on bonuses. This impeded the development of professional standards.

What have been the consequences of the above for (a) consumers, both retail and wholesale, and (b) the economy as a whole?

2. Appendix One illustrates the consequences of the lapse in professional standards. In essence, banks lent money without examining too thoroughly whether the borrower had the ability to pay. Banks were able to reward themselves with bonuses for reckless lending. In many cases these lending practices were potentially illegal.

3. Awarding bonuses to enter into loss making transactions will of course make a bank dysfunctional. Since banks are still finding it difficult to borrow money, over-reliance is placed on government support. In effect, the government are now more exposed to the credit risk of banks operating in the private sector. This could lead to huge problems and may partly explain why customers, both retail and corporate are having difficulty borrowing money.

4. For financial sectors and in particular banks to succeed they must be able to raise private capital. This task becomes impossible if the annual reports of banks are misleading.

What have been the consequences of any problems identified in question 1 for public trust and in, and expectations of, the banking sector?

5. Public trust has broken down significantly with shareholders continuing to steer away from banks. With no equity holders to absorb the credit risk, banks are over reliant on the government for funding and guarantees which introduces a new set of problems. What has emerged in the last five years is that the Basel rules have forced banks to raise more capital but because of weak corporate governance, there is the belief that banks are continuing to conceal losses making the raising of capital difficult. Therefore, in many cases, even banks that are not hiding losses are forced to raise more capital than is necessary.

What can and should be done to address any weaknesses identified? To what extent are such weaknesses subject to remedial corporate, regulatory or legislative action, domestically or internationally?

6. It would appear that the Urgent Issue Task Force (an accounting profession technical committee) misinterpreted a legal opinion when they approved standards that permitted banks to conceal losses. I believe that the committee should examine this area and remind auditors and bankers that concealing losses is contrary to the requirements of company law. In 1993 Mary Arden QC stated in a legal opinion that it would be extremely unlikely that banks would face litigation if they followed the accounting standards to the letter. This may have created some complacency within the accounting profession. However, Arden made it clear in an earlier opinion in 1983 that it is potentially illegal to change accounting standards unless shareholders know exactly the consequences of those changes and what to expect. In 2008 the architects behind the International Financial Reporting Standards issued an assurance to shareholders of banks that losses must be recognised immediately under the IFRS rules. However, auditors interpreted the accounting standards very differently, claiming that they are permitted to delay the recognition of losses on certain loans. It is relatively easy to clear up this confusion and there is also an urgent requirement to do so.

What caused any problems in banking standards identified in question 1? the culture of banking, including the incentivisation of risk-taking;

7. Under the current incentive system bankers are encouraged to gamble excessively. When they succeed their bonuses are inflated but when they fail they can walk away from losses. This encourages banks to leverage up their exposure and to conceal this leverage through off balance sheet activities and also to hide losses by exploiting company law loopholes following changes in 2005.

8. The banking sector appears unwilling to permit any reform that has an adverse effect on bonuses. There is, under the current system a strong correlation between the ability to hide losses and the size of bonuses. It appears that both bankers and auditors are anxious to keep the status quo. Evidence provided to previous House of Lords Committees suggests that it is technically very difficult to reform practices that encourage banks to reveal all losses. This is misleading. Prior to the rule changes in 2005 banks did reveal losses without too much complication.

9. In addition, previous House of Lords Committees were told that the requirement to reveal losses is the responsibility of the regulator and not the accountant. This too is misleading and should be challenged by the current inquiry.

10. Although a difficult problem to solve, the area of Institutional Investors v Private Investors should be examined more thoroughly. In essence, Institutional Investors have considerable voting power but do not normally use this to vote against the destructive practices of some banks. This may be because institutional investors are spared these losses, being able to pass them on to pensioners and savers who invest in funds. Private investors normally take the long-term view and would almost certainly have voted against initiatives to hide losses if they were aware that they existed. Even though they, as a group, clearly have less voting power than institutional shareholders, they could, if they had known about hidden losses, have made an impact, given that it is potentially illegal to hide losses.

Conclusion

11. An artificial situation has developed in the banking world that remains uncorrected. Company law is designed not only to protect shareholders but also to make sure that shareholders run their bank in a manner that protects creditors. Accounting standards were developed so that shareholders could see how the bank was performing through a ‘true and fair’ set of accounts, which is often the only source of information that a shareholder has about the company.

12. The accounting profession, appear to have undermined this protection by concealing losses from shareholders and regulators. Evidence by the accounting profession to previous House of Lords Committees indicates that neither bankers nor accountants are over anxious to correct the situation. I have referenced below recently published newspaper articles to illustrate the problems of ignoring company law1 and the consequences to the accounting profession.2 A third article shows the impact of the Libor scandal on banking.3

APPENDIX ONE

ILLUSTRATION OF HOW BANKERS AWARD THEMSELVES BONUSES FROM DESTRUCTIVE LENDING.

On 1st January 2010 Bank X grants a ten year rolled up loan for £10,000,000 to a property developer. Interest is agreed at 10%. The developer agrees to pay 10,000,000 X (1+10%)^10 = £25,937,423 in ten years’ time (the interest is effectively rolled up). The bank does not look for collateral and the documentation is very weak. On December 31st 2010, it becomes clear that the property developer is in difficulty and there is only a 70% chance that the loan will be repaid. Under the Incurred Loss rules (currently used by the IFRS), the bank is required to record a profit (ie interest income of 10% =£1,000,000) but under the prudent rules, in use prior to 2005, the bank would be required to show a loss of approximately Euro 3,300,000.

These types of transactions are clearly destructive and can easily lead to the destruction of a bank. Yet, because most bonuses are based on IFRS figures, the bank would more than likely pay a bonus to its directors for entering into such a transaction.

This practice continues to exist despite the credit turmoil that the UK and Ireland have suffered.

APPENDIX TWO

ILLUSTRATION OF THE DANGEROUS INTERACTION BETWEEN THE BASEL 2 RULES AND THE IFRS RULES.

(Extracts from research by Flynn/Butler to be published in November 2012 Journal of Risk Management in Financial Institutions vol 6.1 published by Henry Stewart Publications)

There are two aspects of bank risk, the first is uncertainty and the second is insolvency. A problem with the Basel regulations (designed to measure the risks of banks) is that they conflate uncertainty with insolvency. Both concepts have separate characteristics and must be regulated differently.

The simple illustration below shows how Basel enhances leverage through its Risk Weighted Asset system.

A bank with shareholders’ funds worth €10,000,000 is undecided between specialising in the Irish mortgage market or in corporate loans. Basel regulators believe that because mortgages are property backed, they contain less risk and therefore assigns a weighting of 10%. Corporate loans on the other hand are given a weighting of 50%. Regulators generally require that banks hold enough shareholders’ funds to cover 8% of its risk weighted assets. Working backwards, ie €10,000,000/(8%X10%) = €1,250,000,000, the bank can issue €1.25 billion worth of loans. When adjusted by the risk weighting 10%, this gives Risk Weighted Assets of €125,000,000 and 8% of this figure is €10,000,000.

Had the bank instead specialised in corporate loans, the maximum amount of loans it could make would be €250,000,000. The risk weighted assets in this case would be €250,000,000 X 50% = 125,000,000 and when multiplied by the 8% requirement this comes to €10,000,000 which is the shareholders’ funds that the bank must hold.

Most Irish bankers bonus or incentive schemes encouraged bankers to look carefully at the weightings that Basel applied to each category of loans and to specialise in those loans with a low weighting (in the above example Irish mortgages). This would almost certainly have increased incentive payments. However, as we continue the illustration, what is a lot more important is the ‘yield’ or profitability on the loan rather than the Basel weighting.

Consider two banks A and B. Bank A concentrates on loans that have lenient regulatory requirements. Its loans are given a rating of AAA. Since the regulations are lenient, a number of other banks are competing for these types of loans and so the yields (the interest rate that customers are willing to pay) have fallen.

Bank B specialises in loans that other banks avoid but which have more severe regulations applied because of their perceived riskiness Regulators force banks to hold more capital against risky loans compared to non-risky loans. Bank B therefore focuses on high yielding loans that other banks would not touch. The lack of competition allows Bank B to charge a relatively high rate of interest. The probability of default on these loans is higher and the recovery is lower. The details of each loan are shown below:

Bank A

Bank B

1 year floating rate

3%

3%

5 year swap rate

5%

5%

Probability of default

7%

10%

Recovery of collateral

80%

65%

Shareholders’ funds in bank

€ 10,000,000

€ 10,000,000

Yield on loan

4.80%

10.00%

Risk Weighting

10%

50%

At a superficial level, Bank A is less risky than Bank B. Bank A specialises in loans where the probability of default is only 7% as against 10% for Bank B. The recovery from selling collateral is 80% for Bank A and only 65% for Bank B. Because A’s loans are ‘safer’ than Bank B’s, the regulators give a Bank A’s loans a low weighting of 10% (a low weighting allows the bank to lend in large quantities with minimal restrictions—in other words increase leverage) while Bank B’s loans, reflecting the supposedly higher risk, get a weighting of 50%. The reality however is quite different. Bank A is moving towards insolvency and is therefore a lot riskier than Bank B, even if the future cash flows of Bank B are more uncertain. The Basel rules have tended to penalise solvent loans where the yields are high (and therefore profit making) and encouraged insolvent loans where the yields are low. These low yield loans are loss making but the losses are hidden because of flawed IFRS.

Because A’s loans are deemed ‘safer’ by the regulator than B’s, the regulators give Bank A’s loans a low risk weighting of 10% while Bank B’s loans, reflecting the supposedly higher risk, get a weighting of 50%. Under the Basel II rules the maximum amount that A can lend is approximately €1,250,000,000 while for B the maximum amount is €250,000,000. The five-fold restriction on B’s lending simply reflects the fact that B’s loans are given a weighting of 50% which is 5 times higher than that of A.

The regulators require that banks effectively finance 8% of risk adjusted loans with shareholders’ funds. For Bank A the loans are €1,250,000,000 and the risk adjusted loans are 10% X €1,250,000,000 = €125,000,000. Banks must finance 8% of this figure with shareholders’ funds which is €10,000,000.

Bank A

Bank B

Maximum loan size

€ 1,250,000,000

€ 250,000,000

Risk weighted asset

€ 125,000,000

€ 125,000,000

Basel percentage

8%

8%

Required Regulatory Capital

€ 10,000,000

€ 10,000,000

Bank A’s loans have a Basel weighting of 10% while Bank B’s loans have a Basel weighting of 50%. The leverage factor for A is 125 and for B is 25. Leverage here is defined as a bank’s assets divided by shareholders’ funds. The leverage factor for A is calculated as follows:

€10,000,000/(8%X10%) = €1,250,000,000. When this is divided by shareholders’ funds we get 125.

For B, €10,000,000/(8%X50%) = €250,000,000 giving a leverage factor of 250,000,000/10,000,000 = 25.

The Income Statement as calculated in accordance with International Accounting Standard rules is shown below:

Accounting Profit

Bank A

Bank B

Interest Income

€ 60,000,000

€ 25,000,000

Interest expense

-€ 37,500,000

-€ 7,500,000

€ 22,500,000

€ 17,500,000

The laws of supply and demand come into force here. Because of its low weighting, Bank A faces severe competition from other banks and so has to charge a low yield. It charges 4.8% which when multiplied by €1,250,000,000 comes to €60,000,000. Bank A is borrowing on the interbank market and borrows for one year only, intending to roll over the loan at the end of the year. Therefore, the interest it pays is the one year libor interest which is 3% X €1,250,000 = €37,500.

For Bank B, because it faces less competition, it can charge a relatively higher yield. It charges 10%, giving interest income of 10% X €250,000,000 = €25,000,000. As with Bank A, it borrows on a floating rate basis for one year and so pays 3%.

From a superficial point of view, Bank A looks more profitable and is safer. The reality is however very different. If we do an ‘expected loss’ calculation, we see that Bank A although appearing profitable, is almost certainly doomed to bankruptcy while Bank B is likely to remain profitable. In effect, in their published accounts Bank A has not recognised an expected loss while Bank B has not recognised an expected gain. In essence, the IFRS prevents banks from recognising expected losses and expected gains. Prior to 2005 banks were required to recognise expected losses (or provision for bad debts) immediately but not expected gains.

LOAN VALUATION

Bank A

Bank B

Year 1

€ 60,000,000.00

€ 25,000,000.00

Year 2

€ 60,000,000.00

€ 25,000,000.00

Year 3

€ 60,000,000.00

€ 25,000,000.00

Year 4

€ 60,000,000.00

€ 25,000,000.00

Year 5

€ 1,310,000,000.00

€ 275,000,000.00

Break even yield

6.400%

8.500%

Value of loan

€ 1,166,661,619.03

€ 264,777,407.80

Expected loss/gain

-€ 83,338,380.97

€ 14,777,407.80

Credit spread

1.4%

3.5%

Swap rate

5.0%

5.0%

Required yield

6.4%

8.5%

Actual yield

4.8%

10.0%

*Interest €60,000,000 + principal repaid €1,250,000,000 = €1,310,000,000.

The break even yield for Bank A is obtained by reference to the probability of default 7% and (1—Recovery) = (1–80%). 7% X (1–80%) = 1.4%. When this is added to 5% we get the required yield of 6.4%. If however the bank only obtains a yield of 4.8% it is not recovering the full cost of the loan. In other words it is operating below break-even and is therefore doomed to bankruptcy.

The Irish authorities, along with regulators do not seem to realise that the Basel rules have encouraged banks to confine themselves to loans that are property related, loans to governments and loans that have received AAA rating by the credit rating agencies. The regulations for instance encourage lending to governments, including Greece. In Irelands’ case property loans were the cause of the country’s current problems. In mainland Europe, loans to governments and investment in complicated structured securitisation products, rated AAA by the rating agencies, caused devastation in the banking sector. Such loans are given a low weighting by the Basel rules which banks find attractive because this permits high leverage. The reality is that regulation has altered the laws of supply and demand, resulting in too many bankers chasing too few regulatory lenient loans. They have accepted lower yields as a result and these yields are so low that they have encouraged insolvency or bankruptcy.

The policies that the Irish government along with the Basel committee are pursuing suggest that the banking crisis has still a long way to run and that banks will remain dependent on the European Union for financing. The Basel rules are encouraging banks to enter into short term loans and government loans. Long-term loans that are not property related are heavily penalised because of liquidity risks.

In summary, the Basel rules are encouraging banks to take on insolvent loans rather than profitable loans. The low weightings given to insolvent loans (loans to governments, property backed loans and securitisations rated AAA by the rating agencies) has caused an oversupply of such loans leading to yields which were offered well below break-even. Nevertheless because these loans were given a low weighting by the Basel committee, banks anxious to increase leverage (and bonuses) entered into loss making loans because the flawed accounting rules permitted them to record an accounting profit. Had auditors forced banks to reveal the expected losses on these loans banking directors would have found them unattractive and avoided them.

Patrick Honohan, the current govenor of the Central Bank of Ireland has highlighted the consequence of allowing bankers to mislead their shareholders through flawed annual reports—a major source of Operational risk. In essence, by misleading the shareholder into believing that appropriate controls are in place the regulator has assumed that banks were meeting their ‘fiduciary duties to shareholders’ and therefore appropriate controls were in place.

[Extract from The Irish Banking Crisis Regulatory and Financial Stability Policy 2003–2008]4

The Financial Regulators (FR) approach to principles-based regulation relied on the integrity and competence of the Boards and senior management of regulated entities. It also relied on ensuring that these entities have the appropriate compliance systems and controls in place as well as a robust internal audit function.

In the case of one persistently problematic firm—call it Bank A—significant concerns existed within the Central Bank and subsequently the FR about the effectiveness and strength of the Board and governance structures within the organisation. Moreover, serious deficiencies in systems and controls, and failings in the bank’s internal audit unit function, were routinely identified from at least the year 2000 onwards.

The model of supervision applied placed considerable reliance on the Board of Bank A’s fiduciary duties to its shareholders. The FR relied on the assurances provided by the Board and senior management of Bank A and in a general sense it can be said that these assurances proved to be insufficient to ensure sound governance. Nevertheless, the FR persisted with a principles-based approach to the regulation of this institution and the soft moral suasion means of enforcement (although at one point a condition was imposed on its license relating to a governance issue), when it was clear for a number of years that it did not meet the basic requirements of a firm appropriate to this form of regulation.

It should be noted that attempts were made to move beyond moral suasion in relation to dealing with Bank A. In one instance prosecution of Bank A was given detailed consideration but other less intrusive prudential measures were taken. Ultimately, however, these proved to be ineffective.

28 August 2012

1 http://www.irishtimes.com/newspaper/finance/2012/0604/1224317205259.html

2 http://www.irishtimes.com/newspaper/finance/2012/0604/1224317204706.html

3 http://www.irishtimes.com/newspaper/finance/2012/0716/1224320204869.html

4 Central Bank of Ireland. (Patrick Honohan Chairman). The Irish Banking Crisis Regulatory and Financial Stability Policy 2003-2008. p. 64. Dublin 2012.
http://www.bankinginquiry.gov.ie/The%20Irish%20Banking%20Crisis%20Regulatory%20and%20Financial%20Stability%20Policy%202003-
2008.pdf (accessed 22 February 2012)

Prepared 19th June 2013