How banks get away with inventing profits

The Guardian ran an interesting column on 'bankers now producing financial statements that would make Bernie Madoff blush'.

The key takeaway from the column is bank financial statements are meaningless.  This is further confirmation of the observation made by the OECD that bank capital ratios, which are based on balance sheet figures, are also meaningless.

As this blog has said repeatedly, the only way to restore confidence in the financial statements is by requiring banks to provide ultra transparency and disclose their current asset, liability and off-balance sheet exposure details.

With this information, market participants can determine just how fictional the current bank financial statements are and the size of the adjustment these statements require to bring them back to reflecting reality.

The banking crisis is now out of control, made worse by the sloppy bailout structure. The format of the bailout, and the perverse incentives for managers created thereby, have encouraged senior executives to produce financial statements that are still exaggerating profits and capital to an extent that would make Bernie Madoff blush. 

Let me set out three examples of how bankers declare profits despite running loss-making operations as defined by prevailing UK company law, some of which were acknowledged by the Bank of England's Andy Haldane on Thursday: 

1. Underprovisioning for expected losses, resulting in loans being carried at more than their recoverable amounts.... 

2. Marking to model

Under IFRS rules, certain assets (primarily derivatives and heavily structured transactions), for which there is no market, are valued by analogous reference to a synthetic imagined market. The aforementioned Madoff employed this method of accounting. 

3. Fair valuing own debt 

A healthy banking system is characterised by a market environment in which all major entities strong enough to enjoy the revered accreditation "bank" are believed to be solvent. 

When confidence in a bank's solvency drops, the market price of that bank's debt falls. To wipe out a £1bn operating loss by recording a £2.3bn profit based on the assumption that the bank could repurchase all of its debt at the discounted market price is crazy. RBS did this in 2011 Q3.