Change in accounting rules provides some insight into just how overstated bank book equity is

According to a Telegraph article, UK banks are going to have to change the way they account for expected losses on bad loans.  The result of the accounting change will show that bank book capital levels are overstated by tens of billions.

Regular readers know that your humble blogger has been calling for banks to be required to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

One of the reasons I think this disclosure is necessary is that it allows market participants to assess each bank's exposure to bad debt and make any adjustment they think is necessary to bank book capital levels.

Without this disclosure, market participants don't know if the account change has fully captured the distortion in bank book capital caused by the regulators engaging in forbearance and letting the banks use 'extend and pretend' to transform bad loans into 'zombie' loans.

What is clear is that the financial lobby will oppose this move towards transparency.

British banks are to be forced to raise tens of billions of pounds in fresh capital as a result of new accounting rules due to be announced early in the new year....

The fresh requirements will be the result of new international accounting rules regarding when banks take losses for loans on their balance sheets. 

Under current rules, losses are taken once they have been incurred. But the fresh proposals would mean a shift to taking expected losses on loans, with a portion of those losses booked initially, with full lifetime losses booked once a loan has begun to deteriorate by a meaningful amount. 

The changes are designed to give investors and regulators a clearer picture of the quality of a bank's loan book, in a bid to help to avoid a second bank-focused financial crisis. 

It would be better to require the banks to provide ultra transparency and let market participants independently assess the quality of a bank's loan book.  This eliminates any accounting games the bank might engage in.

The Sunday Telegraph understands that the International Accounting Standards Board will publish the new rules in the first quarter of next year. 

It is further understood that recent stress-testing by major UK banks found that, based on the new rules, provisions for loan losses would have to increase between 30pc and 100pc, dependent on the institution.

The history of stress tests is they have not been particularly stressful.  As a result, the increase in the provision for loan losses is likely to exceed these estimates.  This suggests a substantial hole in the bank book capital levels.

This is not at all surprising as we are in the middle of a bank solvency led financial crisis.

Bank of England figures show that they have taken around £35bn of provisions for their UK exposures alone. 

As a result, the major banks would be forced to raise extra funds to keep capital levels in line with regulators' demands. 

Without ultra transparency, who would invest in the banks to provide this additional capital?  There is still no way of knowing what the real losses are.

A report by corporate governance watchdog PIRC earlier this year estimated that the UK's five biggest banks would require an estimated £27bn of capital to cover expected losses in 2011. The banks disputed the claims, however.... 

British and European banks will be subject to the new accounting standards, and their US rivals to a different take on the expected loss model. 

The IASB and its US counterpart, the Financial Accounting Standards Board, had been trying to come up with a global expected-loss rule, but parted ways over the summer. US banks will be forced to take the full expected loss on a loan from the day it is written. But critics suggest this will allow the banks to engage in profit management, writing back losses during growth periods. 

"The point is that if you are booking higher allowances at the start when expectations are most uncertain, there is more room for exploitation," said an industry source. 

The IASB is believed to be poised to publish the new rules in the first quarter, followed by a 120-day consultation process with industry. The final rules will be in place by the end of next year, but banks and auditors will have 18 months to set up systems, so the rules will not be enforced until mid-2015.... 

But [IASB Chairman] Mr Hoogervorst's plans are likely to be fiercely opposed by industry lobby groups on both sides of the Atlantic, due to the benefits of .... less transparent accounting.