The headquarters of Bank of Ireland in 2008 © Bloomberg

Here is a little problem the coronavirus lockdown has exposed in the accounting standards developed for banks in response to the last financial crisis.

You may remember the issue that emerged in 2008. Banks hung back from revealing their losses on loans because they claimed the standards then in force required them only to provide for losses when a loan was actually at, or on the threshold of, default. 

That’s why, say, Bank of Ireland was able to publish a clean set of accounts in the summer of 2008, just months before heeling over and having to request a €5bn bailout.

In response, the standard-setters duly racked their brains and came up with a more “robust” model designed to tease out problems earlier. Instead of one tripwire, this had two.

So when banks made a loan under the new system, known as IFRS 9, they dropped it into a bucket (“stage one”) and took a small provision to reflect some possibility of future default. Each year they repeated the assessment, taking a further provision against any extra losses they foresaw over the following 12 months.

At least that’s what they did so long as the credit backdrop stayed constant. If there was an economic downturn, or the outlook for certain loans deteriorated, then they would hit the first tripwire. That would pitch some loans into the “stage two” bucket, at which point the bank would have to provide against their entire expected lifetime loss. Then, finally, there was the second tripwire — “stage three” — when loans actually went into default.

The problem with the standard comes at the first tripwire — between stages one and two. You’ll notice that this is not concerned with the absolute likelihood of default, but rather a slide down the credit scale. So a very safe loan becoming a safe one will attract provisions, as well as a weaker one dropping to the verge of default. 

The scale of provisioning may also be magnified if the affected assets are of long duration. That’s because while you take the hit of future losses, you don’t offset that with any future earnings from the loans — which may not default for years.

Now consider how that might play out in a synchronised and deep economic decline such as the one that is occurring now with the coronavirus outbreak.

Take an apparently sound institution like UK retail bank Lloyds, which has a monster £350bn book of long-term “safe” assets in the form of domestic mortgages, of which £300bn is at stage one. We can see the impact of the new standards (which came in two years ago) from the difference between the 2016 European stress test it took, which was before the new rule, and the one conducted in 2018.

So in the 2016 test, a macro deterioration required Lloyds to take €600m in additional provisions against this book, according to research by a European investment fund. Now that might have been far too lenient, but in 2018, the same sort of downturn, under IFRS 9, led to €8.6bn of provisions — 14 times as much.

The impact of IFRS 9 alone drove Lloyds’ total provisioning bill for the stress test upwards by a stunning €9.8bn. To put that in context, that rise alone represents 40 per cent of the bank’s £21bn market capitalisation.

Nor is the scenario used in the stress test entirely unthinkable. It posited an 8.3 per cent downward deviation in GDP from its historic baseline over three years. While the outlook remains extremely murky, some expect UK GDP could fall by significantly more than that amount in just one.

Of course, UK regulators are not blind to these pitfalls. Last week they urged companies to go easy on Covid-related provisioning, having already urged them to take advantage of transitional arrangements, which permit them to shield their regulatory book equity from IFRS 9-related losses, only taking them over several years. There are other measures designed to defer crystallising provisions, linked to sectors in receipt of relief, or government-backed loans.

But while this might be expedient to deal with the “cliff-edge” problem, the immediate recourse to forbearance is unfortunate. Not least because it defeats the rule’s whole original aim. 

Remember the “bad” old days when banks used to deal with the difficulty of valuing loans through a process of obfuscation; smoothing their profits almost at will through the use of hidden reserves? Fine-grained accounting rules were devised in the hope of giving greater transparency in the accounts of financial institutions.

There are doubts about the efficacy of this switch, and the propensity of rules-based (and hence gameable) systems to drive out prudence and judgment in the boardroom. But one thing is clear with rulemaking: it can never succeed in enforcing executive accountability if each time there is a crisis, the rule is either waived or withdrawn.


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