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Clueless banks happy to drift in sea of inexactitude

Finance Blogger: Ian Fraser Ian Fraser

Do the world’s leading banks have a firm grip of the true value of their assets, their true exposure to risk (including the likelihood of their borrowers defaulting) and their own true capital strength? And if they do have such information at their fingertips, are they accurately communicating it into the public domain for the benefit of regulators and shareholders?

Such questions ought really to be top-of-mind for any politician or regulator who is seeking to re-regulate the banking sector in the wake of the global financial crisis. They are also questions which—depending on the answers—might cast doubt on the legitimacy of the results of the recent European Union “stress tests” designed to confirm the capital strength of 91 European banks and their ability to survive another downturn.

The onset of the credit crisis, after which many investors began to doubt the accuracy of the audited accounts of developed world banks, prompted me to start exploring such matters. My suspicion the answers to the questions might be “no”, “no”, “no” and “no” has intensified in recent weeks; it was reinforced by an article in The Economist. The article, headlined “Computer says no” and published on July 24th, quoted an anonymous ex-RBS source as saying:

“The reality was you could never be certain anything was correct … Reported numbers for the bank’s exposure were regularly billions of dollars adrift of reality. Finding the source of the error was hard.”

This is astonishing. If true, it suggests that under former chief executive Sir Fred Goodwin, RBS’s internal management systems had been allowed to atrophy to the extent they had become incapable of channeling accurate information to those at the top; and that scope for inaccuracies in the bank’s accounts—audited by ‘big four’ accountancy firm Deloitte—must have been immense.

The anonymous quote corroborates the findings of some research I've been doing into RBS for a planned BBC documentary. A number of former RBS executives and advisers have told me that Goodwin was so obsessed with cost-cutting and empire-building that he refused to invest in the sort of internal IT systems that would have permitted timely and accurate data to flow around the bank.

The Economist article points out that the problem is by no means limited to RBS. Indeed it claims that it is common to most of the world's leading banks, and says that it stems from the fact many are still use the original mainframe computers that they first installed in the 1960s(!)

The article adds that “over the years more and more systems have been slapped on”. Most leading banks have grown by acquisition, giving rise to a veritable palimpsest of systems, accounting methodologies and approaches to risk valuation.

Another problem is that, even if the banks did have access to 100% reliable internal data, few would be inclined to communicate this to their regulators or investors. It seems few banks have overcome their pre-credit crisis addiction to obfuscation and fudge - even though these precipitated the crisis.

Bankers' continuing desire to drift in a sea of inexactitude became clear in early July, when lobbyists for the US banking sector launched an email and web campaign aimed at seeing off any extension of mark-to-market ("fair value") accounting rules. The change, proposed by the Financial Accounting Standards Board would force leading American financial groups such as Citigroup and Wells Fargo to write down billions of dollars of assets.

The American Bankers Association fears that the FASB's proposed extension of fair value accounting to all financial instruments, including loans, as opposed just to securities might make otherwise "strong" banks look as though they are under-capitalized. Plus ça change!

Further reading on the reliability of bank management information and audits

Tags: audit , banking , capital adequacy , fair-value accounting , internal audit
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  1. clansman2 says:
    Sat Jul 31 02:18:56 BST 2010

    I think it may be worth commenting on this article just to qualify it a little. There is a distinction between (Financial Services) regulation and supervision; what is known as Pillar One and Pillar Two (respectively) nowadays. This distinction has pertained for many years both in the UK and the US; a good exposition of the operational distinction in the UK in the 1970s is in the essay by Maximillian J B Hall titled 'UK Banking Supervision & the Johnson Mathey Affair'. I refer that essay since 'things were so much simpler then' and it is difficult for a non expert to wade through the voluminous Basel (2,3 or +) output and capture this distinction. But it applies to the argument here. That essay is also relevant again today since it describes the the Bank of England as supervisor! Regulatory numbers are essentially public, that is necessitated by the relatively new idea of 'Market Discipline'. Accounting Disclosure is on the same footing, necessarily transparent. Supervisory numbers (on the other hand) are essentially private and 'entre nous' between the supervisor and the supervised institution. This is partly because supervisory numbers (for a single institution) are predicated upon a macroeconomic outlook and thus are in essence conjecture or heuristic. No supervisor can impose a single macroeconomic view on every institution, that way through correlation; the equity prices of financial institutions will all head-off in the same direction, i.e. market swings will occur. (We don't want that) So although we are all driven towards total transparency by this recent crisis, financial institutions are different in this respect, (amongst others); they cannot be completely transparent to the man on the Edinburgh tram, that is not realistic. Supervision is a matter of finesse, a matter of expertise. However Regulation and Market Discipline are predicated on transparency & you could argue that banking executives (& the public) should be aware of the limits and the extent of transparency in the relatively different domains of regulation (& market discipline) versus supervision. Hope this helps.
  2. ajmcneil says:
    Fri Jul 30 12:04:58 BST 2010

    Good article. I think your suspicions may be well founded. I have a forthcoming paper in the Journal of Banking & Finance ("Integrated Models of Capital Adequacy - Why Banks are Undercapitalised") arguing that fully integrated enterprise-wide risk models are superior to the piecemeal, risk-silo approaches that currently dominate risk management practice. While this message meets with general agreement, I also encounter widespread skepticism that any bank has the IT systems and resources to develop genuine fully integrated solutions.

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