Rule on auditing loan losses set stage for bank guarantee catastrophe

Prominent among the many imponderables of the Irish banking crisis is what would have happened if the banks had properly disclosed the extent of their losses in 2007. The best answer is things would have been different, but they might not have been any better.

Without a doubt the lack of transparency about the property-related losses building up in the banks contributed significantly to the biggest single misstep of the crisis: the blanket guarantee of all the Irish banks’ debts and in particular their unsecured bonds. What seemed, on the basis of what was known on the night of the September 30th, 2008, to be a manageable financial commitment by the exchequer turned out to be a black hole so large that it bankrupted the country.

Part of the explanation for this catastrophic misjudgment was that the then government did not know what it was letting itself – and by extension the taxpayer – in for. Pretty much all it had to go on was the audited accounts of the banks and a number of reports done for it by PricewaterhouseCoopers (PwC). Both suffered from a common flaw which meant they failed to give an accurate picture of the losses the banks were facing.

Well-intentioned rule

The common flaw was the rule governing the reporting of loan losses set by the

International Accounting Standards Board

(IASB). In crude terms the rule meant a bank could consider a loan to be nonperforming only if the specific terms of the specific loan were broken, ie if a repayment had been missed. In theory the bank could not take into account anything else it knew about the borrower when deciding whether or loan was nonperforming.

The rule was well-intentioned and meant to stop banks smoothing their profits between years by using non- specific bad-loan provision.

There is some debate as to whether various other measures under company law allowed – if not compelled – the banks to look at other factors. But in any case the Irish banks and their auditors chose the narrow interpretation of the rule, with a catastrophic result. As the credit markets froze post the collapse of Lehman and Irish property prices buckled, the banks were still reporting profits based on incredibly small bad debt provisions.

The government of the day commissioned PwC to carry out an independent assessment of the banks’ property exposure and it came back with a not too dissimilar picture to that painted by the banks themselves.

This was because PwC also approached the task on the basis of the existing rules. In many ways they had no choice but to do so, as to take any other approach would be tantamount to saying the work they had done in their previous role as auditor to AIB had been incorrect.

Deep denial

The only people who could reasonably have been expected to have shouted stop were the banks themselves and that would have been the equivalent of turkeys voting for Christmas. In any case across all the banks there was deep denial at board level about the problem.

As a result the government found itself in late 2008 with a banking system in crisis but with no reliable assessment of just how bad things were. If it had known, it is hard to believe it would have guaranteed all the banks or extended the guarantee to the unsecured bond holders.

Would it have made a difference? Who knows? There are too many ifs and buts. In theory, Anglo Irish Bank would have been let go to the wall if the true extent of its losses had been clear. But there were other factors in that decision which have not yet been fully ventilated.

Likewise, even if the State had not guaranteed the subordinated bonds of the banks, would we have been allowed burn them?

It is likely that we would have faced a deep economic crisis anyway, but just one of a different complexion.