Government Flying Blind On Banking

Sunday 8th November By Ian Fraser

Steve Baker: The government is flying blind on banking

8th November, 2015

_55406355_-1In a stark warning to the government, the MP Steve Baker has said we’re flying blind where RBS and the wider banking system are concerned, as accounts prepared using International Financial Reporting Standards (IFRS) cannot be relied upon.

In what was the stand-out contribution to last Thursday’s House of Commons debate on RBS and the future of UK banking, Baker, the Conservative MP for Wycombe since May 2010 and chairman of the all-party parliamentary group (APPG) on economics, money and banking, said RBS was almost certainly in a more parlous state than its IFRS compliant accounts suggest.

Baker, a former engineer officer in the Royal Air Force, worked for various information technology firms until 2006, when he joined the US investment bank Lehman Brothers as “chief architect of global financing and asset service platforms”. He left the New York-headquartered firm after it went spectacularly bust in September 2008(a disaster for which he bears no responsibility).

Addressing the banking debate in the House of Commons, Baker said that IFRS, introduced by the International Accounting Standards Board (IASB) under the chairmanship of Sir David Tweedie in 2005, have served as a distorting prism for the banking sector. He told parliament that the Standards have made it all but impossible to tell whether RBS, still 73 per cent owned by the British taxpayer, is “in the position it appears to be in”.

This ought to be of immense  concern to anyone with an interest in the bank, including UK Financial Investments, the agency that’s supposed to fulfill a “stewardship” role on behalf of the UK government but is actually a fig-leaf for the Treasury, RBS’s auditors Ernst & Young, the bank’s executive team led by Kiwi-born Ross McEwan, and its board of directors which since September has been chaired by former FSA chairman and chief executive Sir Howard Davies. If Baker is right, these guys are effectively flying a plane with faulty instruments — and the aircraft may be 2,000 feet higher or lower than they think, and might be travelling 123 km/hr faster or slower than they think.

Baker said: “It is highly unlikely that RBS is in the state it appears to be in. … In such circumstances, the paying of dividends, which has been proposed, would be extremely unwise”.

“I am extremely uncomfortable with the idea that we understand the true and fair position of RBS, or indeed any other banks, because of the imposition of IFRS accounting standards. Particularly in relation to RBS, that has meaningful consequences when it comes to thinking about selling the shares. There are also consequences that we should consider when any consideration is given to paying out dividends.”

He added: “I encourage the government to take all possible steps to establish the true position of RBS and the entire banking system, by comprehensively investigating the flaws in IFRS that have been well set out.”

As I wrote in Shredded: Inside RBS The Bank that Broke Britain, IFRS gave banks free rein to distort and magnify their financial strength, partly because of the way derivatives are accounted for and can be used under the controversial Standards. The biggest flaw of the Standards is they give bank managements and their auditors too much latitude in the valuation of assets which, in the boom times, creates an illusion of capital strength and profitability and encourages managements to go out and take more risk by indulging in more and more poor-quality lending, which creates a Ponzi-like scenario in the frothiest market sectors. They also enable bank managements to make ludicrously low provisions for bad debts.

In an August 2010 letter to the Accounting Standards Board (ASB), Tim Bush, head of governance and financial analysis at Pensions & Investment Research Consultants (PIRC), said that the adoption of IFRS had led directly to a “regulatory fiasco” and to the global financial crisis of 2007-11, adding that the authorities’ insistence on sticking with IFRS, despite its well-documented flaws, continued to pose a severe risk to the financial system.

Though he did not say it during last week’s debate, Steve Baker also opposes quantitative easing, believing its inevitable consequence will be a worse crisis than the one that it sought patch up.

A founding member of The Cobden Centre, an educational charity promoting honest money, Baker introduced a Private Member’s bill to the House of Commons in March 2011 with a view to “requiring certain financial institutions to prepare parallel accounts on the basis of the lower of historic cost and mark-to-market for their exposure to derivatives”.

Largely thanks to the fact that most politicians are either too dim-witted or lazy to know or care about important matters like accountancy and accountancy standards, or else are captives of vested interests in the City of London, the bill failed to gain sufficient parliamentary support to take it through to a second reading and therefore went into abeyance.

Here is Steve Baker’s speech to the “Backbench Business: Royal Bank of Scotland and the Future of UK Banking” debate in full, as it appears in Hansard. The debate was opened by the Labour MP Kate Osamor:-

“Some lessons of history are so well established as to virtually be axioms: the Government ought not to own banks and private enterprises ought not to be bailed out by the taxpayer. Unfortunately, the government does own banks and those banks were bailed out by the taxpayer. I think that the taxpayer bailouts, which involved the privatisation of profit combined with the socialisation of risk, together with all the conduct issues that we all know so well, have done a great deal to undermine faith in the market economy, which we know is the only way to sustain billions of people on the face of the earth.

“Some of the issues that have come up today go to the heart of how we should structure a market economy. In my view, in a market economy there should be a plurality of ownership models for banks. One of the great mistakes of the 1980s was the demutualisation of building societies. … As a teenager, I knew instinctively that the mutual model aligned interests in a way that the shareholder model did not. I was opposed to the demutualisation, or carpet-bagging as it was called, that went on then. These days, I have more theoretical grounding for my views and I certainly believe that we should have a more diverse banking sector, with more mutuals and co-operatives.

“I should say briefly that the systemic problems that have affected the entire banking system around the world, irrespective of ownership models, are symptomatic of far deeper problems in the institutional arrangement of money and banking, which I have talked about at great length on other occasions.

“I am an old English liberal free-trader and I think the fundamental problem is the chronically inflationary system of fiat money. …

“I have two long-standing misgivings that come to a head in RBS. The first is about the effect of International Financial Reporting Standards (IFRS) on our ability to see the true and fair position of banks. The other is about the stress tests. I am grateful to Professor Kevin Dowd, Gordon Kerr and John Butler of Cobden Partners for their advice, but any errors or omissions are my own. I should say that I have no financial interest whatever in Cobden Partners, although it was a spin-out from the Cobden Centre, which I co-founded to advance the ideas on which they are now working.

“I have said many times that IFRS allow, enable and encourage banks to overstate their asset values, and therefore their profits, and to understate their losses. In May, we conducted an exercise in which we compared the accounts of RBS with the statement of its accounts in the asset protection scheme. We believed that its capital was overstated by £20 billion. We had a meeting with RBS at which that was admitted.

“If it’s the case that the IFRS encourage banks to overstate their capital positions to such an extreme degree, I am not in the least convinced that we are selling something that we truly understand. Indeed, as the hon. Member for Edmonton (Kate Osamor) was opening the debate, on which I congratulate her, Gordon Kerr texted me to say that if we broke up the bank into 130 pieces, it would reveal its insolvency. I am not asserting the insolvency of RBS; what I am saying is that with the IFRS the way they are, we simply cannot know whether RBS is in the position it appears to be in.

“In such circumstances, the paying of dividends, which has been proposed, would be extremely unwise. It would risk exposing taxpayers to future claims from stakeholders ranking superior to those common stakeholders. The claim will be that their entitlements have been improperly paid out as dividends, when those funds should lawfully have been held back and attributed to creditors and depositors. Tim Bush of Pensions & Investment Research Consultants, Gordon Kerr and others argue that we should have strong reservations about the integrity of the numbers and the ability of the firm to distribute profits under the law.

At this point Ian Blackford the MP for Ross Cromarty and Skye, who was a managing director at Deutsche Bank until 2002, interjected: “The hon. Gentleman is painting an interesting picture of the deficiencies of the IFRS. If we believe it for a second, does it not behove the Government to do a proper analysis of the true value of Royal Bank of Scotland, given that we own over 70% of it?”

Steve Baker replied: “I banged on in the last Parliament about the IFRS and their shortcomings. Indeed, I introduced a Bill to require parallel accounts to use the UK generally accepted accounting principles, precisely because I think there is a serious problem. I refer the House to Gordon Kerr’s book “The Law of Opposites”, published by the Adam Smith Institute, which not only covers this problem in detail, but explains how it feeds into the problem of derivatives being used specifically to manufacture capital out of thin air to circumvent regulatory capital rules. That is an extremely serious problem that might mean that the entire banking system is in a far worse place than we might otherwise think.

the Tory MP Jeremy Quin who worked for Deutsche Bank and NatWest Securities in the City of london, where was latter a managing director in the investment banking, before becoming MP for Horsham in 2015, seemed taken aback by Baker’s claim. He said: “I am genuinely curious about what my hon. friend is saying. A lot of work was done on the balance sheet of RBS at the time of the asset protection scheme. Does he not think that any accounting issues would have been picked up at that stage?

Steve Baker replied: “As I said earlier, we compared the asset protection scheme’s accounts with those of RBS and found a £20 billion difference in capital. When I write to my hon. Friend with the details from the IMF, I will introduce him to the people who did that work. I would be glad to sit down with him and my advisers and see what he thinks, because I recognise and respect his vast experience. I am, of course, only a humble engineer who sat in banks asking people how the system worked and found that they often could not tell me.

“These concerns are not ones that I have made up. I have in my hand a letter from the Local Authority Pension Fund Forum that explains to our commissioner at the European Union [Lord Hill] in considerable detail over eight pages what is wrong with IFRS. I would be pleased to share that with Members who are interested.

“I am extremely uncomfortable with the idea that we understand the true and fair position of RBS, or indeed any other banks, because of the imposition of IFRS accounting standards. Particularly in relation to RBS, that has meaningful consequences when it comes to thinking about selling the shares. There are also consequences that we should consider when any consideration is given to paying out dividends.

“Secondly, I want to raise Professor Kevin Dowd’s extended criticisms of the stress tests. He has made the point to me that under the 2014 stress tests, RBS had a projected post-stress, post-management action ratio of capital-to-risk-weighted assets of 5.2%. That was sufficiently poor that the bank was required to take further action on its capital position. Of course, it now wants to hand out dividends. That seems to both of us to make no sense. He continued:

“This 5.2% ratio compares to the 4.5% hurdle the Bank used, which is actually less than the 7% imposed on UK banks last year, and much less than the 8.5% to 11% minimum that will be imposed when Basel III is fully implemented in 2019.”

“The range arises because of the counter-cyclical capital buffer. That is rather bizarre because it appears that RBS did not meet the Bank of England’s minimum requirements in the stress tests.

“I am afraid that it gets worse. Because market events do not follow a normal distribution, there are severe problems with the risk-weighted assets measure that perhaps even render it useless. Therefore, the only measure that really makes sense is the leverage ratio, which is the ratio of capital-to-total assets, with none of the risk-weighting. Under Basel last year, the absolute minimum leverage ratio was 3 per cent and the Bank of England expected UK banks to meet that minimum. That 3 per cent minimum was low. Some of my advisers suggest that a minimum of 15 per cent is necessary, and possibly even double that for the bigger banks. That would be a radical departure. What did RBS achieve under the stress tests? It achieved 2.3%.

“I am grateful for the work of Kevin Dowd, Gordon Kerr and John Butler at Cobden Partners on the IFRS and the stress tests. The problems that they have put in front of us are potentially extremely severe. I encourage the government to meet my colleagues, to look at this matter again in great detail and to understand what has happened with this accounting, so that they can see what it means for our ability to see the true position of banks and how it incentivises structures that we subsequently find, as was pointed out earlier, are of no social value—structures that often serve to deceive and to create an impression of capital where there is none.

“It is highly unlikely that RBS is in the state it appears to be in, and I agree with those who have called for diversity in ownership models. The challenges of providing those diverse banks out of RBS in its current condition are probably insurmountable, and I would welcome government policy action to encourage mutuals and co-operatives. Above all, I encourage the government to take all possible steps to establish the true position of RBS and the entire banking system, by comprehensively investigating the flaws in IFRS that have been well set out.

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