Saturday, February 25, 2012

Is there any truth to bank earnings presentations when banks use 'Alice in Wonderland' accounting?

In a Telegraph article, RBS chief Stephen Hester confessed that bank regulators have blessed RBS hiding losses on and off its balance sheet and only recognizing these losses as RBS generates the earnings to absorb them (an example of the Japanese model for handling a bank solvency based financial crisis).

One result of this is what Mr. Hester refers to as 'Alice in Wonderland' accounting.

The RBS chief admitted that since its £45bn bailout in 2008, the lender had taken losses when it could "afford" to and used profits to "finesse" its results. 
"We have to finesse it with our own profits as we go through. Each year we have, in a sense, a budget for making losses for clean-up – and the better or worse our profits are, the better or worse that budget is and the faster or slower that we can go," said Mr Hester, adding that the bank had "never" had sufficient capital to recognise all its losses upfront.
The question is, with regulator blessed 'Alice in Wonderland' accounting, is there any truth to bank earnings presentations?

In a column in the Guardian, Rob Taylor looks for an answer by asserting "the truth is in Lloyd's latest results presentation....somewhere".

This is the fourth year we have watched banks claim improvements in their core areas – and then turn round and tell us there is still garbage inside their businesses that needs to be written off. 
This just happens to coincide with the start of the financial crisis and the regulatory blessing of and bank adoption of Alice in Wonderland accounting.
For the layman, operating profits are key indicators of the health of a business. As long as a company has the income to cover one-off losses – or sufficient capital tucked away to absorb these losses – the business can, in theory, continue to run another year and make more money.  
Of course, chief executives and boards don't like to have to tell shareholders they need to write down high levels of legal liabilities and restructuring charges, let alone do so for several years in a row. 
The strategy for most new chief executives is to fully audit and find the rubbish lurking in their businesses – then clear it off their books as soon as possible. 
This strategy runs counter to the Japanese model of delaying recognition of the losses until the bank has the capacity to absorb them through earnings.

Under the Japanese model, loss recognition is balanced against the fact that management doesn't like reporting write downs and restructuring charges for several years in a row.  The result is that banks report earnings while they are still hiding additional losses.
In the case of Horta-Osório, he announced early in his tenure that he would write-off PPI repayments and the restructuring charges one assumes were necessary for his longer-term growth strategy. 
RBS's chief executive, Steven Hester, has had several years to find the bad bits and rid his bank of its financial liabilities. 
Of course, banks will have to write down some sort of unanticipated expense most years. But let's just hope that Hester and Horta-Osório have finally got these big charges out of the way.
There is no reason for market participants to trust the bank's financial statements since they reflect Alice in Wonderland accounting and may or may not be hiding significant additional losses. This has directly contributed to the interbank lending market freezing as each bank knows what it is hiding through Alice in Wonderland accounting and assumes that other banks are also hiding losses.

Without ultra transparency under which banks disclose their current asset, liability and off balance sheet exposure details, there is no way of knowing if the banks have gotten the big charges out of the way.

Finally, so long as regulators pursue the Japanese model for handling a bank solvency based financial crisis and bless Alice in Wonderland accounting, regulators will be undermining confidence in the financial markets.

Since the 1930s, confidence in the financial markets has come from the idea that market participants are able to access all the useful, relevant information in an appropriate, timely manner and independently assess this information prior to making their investment decisions.

When regulators deliberately bless the withholding of all the useful, relevant information in an appropriate, timely manner, they undermine confidence (and this is before the question of is it legal is raised -- see IndyMac and its regulator, OTS)

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