In November 2012, the Bank of England released its autumn Financial Stability Report (FSR). Chapter two shows the market capitalisation of the banks is significantly lower than their reported asset values. This indicates market mistrust of the accounting numbers amongst various other problems. 

While the FSR states that some banks’ assets are overvalued by billions, it seems clear that current accounting rules for valuation of loans are responsible for this situation. Banks will have increasing difficulty raising much needed additional capital whilst there is mistrust in their accounting numbers.

Reading the FSR shows how the UK’s current accounting regime, introduced in 2005, has allowed the banks to under-provide for their loan losses, which means they are overstating their balance sheet values.  The changes came in via a 2002 EU Regulation to harmonise accounting rules across capital markets in EU member states.

The Regulation did not mandate an EU owned and controlled accounting standard setter . Rather the role was entrusted to the International Accounting Standards Board  (IASB), a private sector body,  with an impossible- to- achieve core objective of  being the world’s only accounting standard setter.  A convoluted endorsement process was set up to accept the standards for EU application.

IASB claims to be independent, but independent of what?   Although based in London, IASB’s Foundation is registered in the US state of Delaware.  Shortly after the EU Regulation was passed, it was announced the IASB was converging its standards with the US standards setter.

The IASB hoped the US Securities and Exchange Commission (SEC) would approve their standards for US markets. So before EU Regulation took effect, the IASB had already compromised its independence to the US standard setters.

Thus in 2005, EU listed companies had to comply with an accounting model heavily influenced by the US rules based accounting system, which is predicated on litigation defence.

The new rules changed how UK banks provide for their loan losses.  Before 2005, a prudent expected loss regime was applied.   Banks would make provisions against losses that were already identifiable, and further provisions would be made where the lending was high risk – such as sub-prime mortgages and against other predictable risks which had not yet arisen.

Banks compensate for inherently high risk lending by charging higher interest rates. The increased income is countered by non specific provisions against the risky portfolios.

The post 2005 loan loss provisioning regime is based on an incurred loss model, which only allows provisioning where an identifiable event justifies a provision. So as the banks’ high risk lending rapidly grew in the run up to the crisis, provisions were not made after 2005 against the risky portfolios where no events had triggered them.

Interest was earned, the potential losses were not accounted for and up went bank profits and bonuses. Most UK taxpayers and shareholders would not have known of the damage caused by an obscure accounting rule.   This was known about by UK preparers, auditors and accounting regulators, who kept remarkably quiet about it in the run up to the crisis and afterwards.

In 2009, the G20 (20 major economies group) recommended accounting change. Loan loss provisioning was not the only rule which had inflated bank profits.  Four years later, agreement on changes has not been reached because of the convoluted process involved. In 2012 the US SEC backed off of the convergence project so IASB’s global mission failed but still no change to the accounting.

The delays have gone on for long enough.  The government should be pressuring the European Parliament and the Commission to think again about trusting the IASB with European accounting and start revising the 2002 Regulation which brought this defective system into the EU.

It’s high the time the government took it head out of the sand, and authorised UK banks to override these defective accounting rules.

Stella Fearnley is Professor in Accounting at Bournemouth University. She has  given oral and written evidence on the banking crisis to the Parliamentary Commission on Banking Standards and to the House of Lords Economic Affairs Committee


Accounting in UK Banking Sector Needs Drastic Reform
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