Scrap mark-to-market accounting or face further crisis, warn investors

The interrogation of Barclays' newly-installed chief executive Bob Diamond by the Treasury committee of the House of Commons last Tuesday was an unsatisfactory affair.

The two and half hour session gave the politicians the opportunity to “grandstand” and channel popular anger about bankers’ bonuses, tax avoidance and reluctance to lend to SMEs.

But the politicians on the panel seemed keener on venting their spleens than on getting their heads around more complex issues such as addressing the flawed structures and accounting standards that continue to jeopardize the banking sector.

This brings me on to a more productive parliamentary session in the UK - the meeting of the House of Lords Economic Affairs Committee on January 11th.

During this session a group of leading UK-based fund managers told the Lords what they thought of the audit profession. There was near unanimity that revising accounting rules and auditing standards would be a good starting point if further crisis is to be avoided.

The fund managers told the committee that International Financial Reporting Standards (IFRS) had enabled banks to live in a fool's paradise where risk could be buried and profits and bonuses inflated. In a report in Financial News, the financial journalist Mike Foster explained:

"The devastating assessment of the accounting rules was articulated for the first time by some of Britain's biggest institutional investors."

Iain Richards, head of corporate governance at Aviva Investors, told the lords that IFRS, or mark-to-market accounting, was a distorting prism through which to look at bank performance. He said this was because it legitimized giving fantastically high valuations to assets at the peak of the credit bubble - even though the market for such assets was thin or non-existent.

Richards was also concerned that the use of IFRS meant that banks made very light provisioning for bad debts ahead of the crisis.

Instead of highlighting problems, IFRS had exacerbated them, enabling banks to deceive their investors - enabling them to portray themselves as massively profitable when in fact they weren't.

This enabled the banks to make imprudent payouts to both executives (in the shape of bonuses) and to shareholders (in the shape of dividends) which in reality they could ill afford to make. This cavalier approach to their own finances is one reason they ended up costing taxpayers such a fortune to bailout. Richard said:

“IFRS is extremely pro-cyclical.It facilitated and exacerbated the credit bubble ...There were some very clear risks inherent (in the banks)...the risks were extremely material."

It was only once the banking and financial crisis struck and liquidity froze in 2007 that the distortions became apparent, said Richards. He added:

"The double-digit billions pumped into the banks went to plug the gap created by both bonus distribution and dividend distributions that were made just preceding the crisis."

His assessment was backed up by other senior fund managers in the session, including David Pitt-Watson of Hermes; Guy Jubb of Standard Life Investments; and Robert Talbut of Royal London Asset Management.

Pitt-Watson said "we as investors and society" need to see the re-introduction of a principle-based accounting system that includes prudential and on-going assessments of risks.

As Telegraph financial journalist Louise Armitstead points out, Tim Bush, a City veteran and a former fund manager at Hermes, last year warned the government that IFRS amounted to a "regulatory fiasco" that had contributed to the crisis and continued to pose a severe danger to the system.

As I mentioned in an earlier blog post, Bush believes that the use of IFRS may even have obliged the boards of UK banks to commit illegal acts. He said following IFRS, as applied in the UK, was:

“...positively contrary to the objective of directors discharging their duties properly. False profits, hidden losses and hidden gearing (note: hidden losses are also hidden gearing as capital is overstated) are possible with IFRS.”

Richards and the other investors on the panel argued that auditors ought to be allowed to speak directly to shareholders and that the lack of competition in the audit market must be addressed.

Currently the “Big Four” firms - PWC, Deloitte, KPMG and Ernst & Young - have the market sewn up, which commentators such as Re: The Auditors' Francine McKenna argue makes them unassailable and more prone to audit sloppily.

The panel of investors said the dominance of the Big Four ought to be broken up, perhaps with the help of mandatory retendering. “Eight seems to be a credible number,” Jubb said.

Robert Talbut, chief investment officer at Royal London Asset Management, summed up the problem:

“Prudence has been considerably lost in the way accounting standards has been operating.”