Short view: Accounting for banks
THEY say an economist is someone who is good at figures but didn't have the personality to become an accountant. When it comes to judging the health of banks, the assessment of accountants can be very far removed from economic reality.
The problem is that since 2005, accountants have relied on International Financial Reporting Standards (IFRS) to draw up financial statements for banks. These accounting rules are procyclical, in the sense that they tend to boost lending during booms and curtail lending during downturns.
The difficulty arises because of the treatment of loan-loss provisions. Authorities in many countries have interpreted the rules to mean that banks cannot make provisions against losses that are fully expected but have not yet happened. A bank can only make a provision if a triggering event occurs, such as when a borrower misses an interest payment. This means that loan-loss provisions are very low during the early stages of a downturn, as the triggering events have yet to happen.
Many developers have clauses in their loan agreements that allow them to roll up interest payments into the loan principal. So even if a developer has no hope of repaying the loan, the accounts will not show that debt as an impaired loan since no triggering event has occurred.
Since provisions are a charge against profits and capital, the rules mean that a set of accounts based on IFRS will exaggerate banks' capital position at this stage of the cycle. A recent report by accountants PricewaterhouseCoopers on the financial position of Irish banks found that all the institutions reviewed were in excess of regulatory capital requirements as of September 30 -- the date on which the government guarantee scheme was announced. Markets and economists beg to differ.