Could this actually be true?

This all sounds a bit recondite but is the man onto something here?

He’s been called “obsessive” on more than one occasion. Bush’s research is detailed and complex. But his argument is essentially that the British system of bank accounting provided by the Companies Act 1879 should never have been modernised by the new International Financial Reporting Standards (IFRS) that were introduced in Britain in 2005.

The driving force for change was a growing irritation with banks apparently making profits from bad-debt provisions. Under the old rules, banks had to mark down loans deemed to be at risk of default. However, when some bad loans were repaid, the banks were seen to be making bigger profits.

The drive for change came from America where so-called IFRS39 was introduced to bring some solid numbers to bank accounting. Under the new “incurred loss” system, loans were either good or bad. Accountants no longer had to workout the likelihood of defaults; loans were only marked down once they had actually defaulted.

Given the usual warning that I\’m certainly not an accountant there is at least a spark of reasonableness to the argument.

It doesn\’t work for securitisation of course, for there, given that they are traded and tradeable instruments, marking to market would be the appropriate treatment. But for loans that are actually on the books and which are going to stay on the books, some measure of provisioning for possible to likely default seems an entirely reasonable idea.

And if such provisioning was no longer allowed (which seems to be the implication) then yes, I can see how this would lead to large problems.

However, there\’s something creeping around at the back of my memory here. Something about tax.

Such provisions were tax allowable: if you\’d just made a provision for a debt that was going to bounce clearly that\’s a cost of the whole business and so is tax deductible. And so there was a temptation (to put it mildly) to over-provision so as to reduce the tax bill. (There\’s also the hugely attractive temptation of over-provisioning in good years so as to be able to reverse them in bad and thus smooth earnings.)

The bit that\’s rattling around in the back of that memory is that there was some anger from the tax side about this \”tax dodging\” which is why such provisioning was to be discouraged.

But what if he\’s actually correct? That it\’s the accounting regulators themselves who raised the risk level of the banking system? If it\’s really the government that fucked up imposing these rules then how do bank shareholders and all the rest get their money back from the people who fucked up?

I must also, sadly, be fair to Ritchie here. This is a point he\’s raised before….my only justification for ignoring it is that he didn\’t explain it all in a manner that I could understand. Sorry.

5 thoughts on “Could this actually be true?”

  1. Looking at the individual loans must have required some local knowledge and would be labour intensive. The new system offered an incentive to stop looking at the individual loans and save lots of money by making the loan checkers redundant. The banks probably thought that any increased risk was more than balance by the savings. Its strange the old system seems to have had the unintended consequence of making banks cautious about their loans. The new system had the opposite effect.

  2. First up, this isn’t about tax. Remember, reported financial accounts and tax accounts are completely separate. IIRC the Inland Revenue never allowed companies to offset bad debt provisions against taxable profit (only actual bad debts).

    More generally, Bush has something resembling a point, but is overplaying it to a ridiculous degree.

    It is probably true that the fact that provisions for bad debts (remember, these are based on banks’ estimates of likely bad debts) weren’t reported in headline accounting figures meant that uninformed shareholders forgot completely about their existence.

    It is definitely untrue that banks weren’t trying to calculate these risks, that they didn’t use them as internal KPIs, or that analysts and regulators didn’t also monitor them. The problem was, the models they were using to calculate these risks were wrong.

    So if they’d continued using UK GAAP rather than IFRS, the result would’ve been a small hit on profits based on their (low) expected default rates, not anything like a reflection of the actual risks they were holding.

    Tank: IFRS isn’t a government body. It’s run by the accounting profession.

    Eddy: no, the reason banks stopped being cautious about their loans was because they thought they weren’t bearing the risk, because they were securitising them and selling them on.

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  4. Hang on. There may be some shifting of the timing of tax payments, but that’s about it.

    If you reduce your profit and hence tax liability by provisioning for bad debt, and it then turns out to be good, you make a bigger profit and hence pay more tax at that later point.

    I’m struggling to see that there’s either more profit or less tax paid (or both) overall.

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