Sunday, 15 February 2009

A Pig In A Poke

“Why won’t the banks resume lending?” is a cry frequently heard at the moment. As it happens, it is not exactly an accurate cry because the banks are still lending, it is just that the volume of lending has reduced, albeit reduced greatly. In the UK, this, in part, is explained by the disappearance of foreign owned banks lending into the British economy. For example, the Icelandic banks and the Irish banks have, by and large, withdrawn to their home territories, thus reducing the lending capacity within the British economy. There is, however, another factor at play that will become significant in the longer term.

When considering a loan application, bankers apply two key principles of lending – does the borrower have the ability to repay the loan and to service the debt, and what security can the borrower offer to cover the lender’s position if events turn out worse than planned. These areas, in recent years, have broken down. Indeed, one could argue that it is the malfunctioning of these basic principles that has undermined confidence in the whole financial system

The ability to service the debt and repay the loan is generally determined by the accounts presented by the borrower to the lender. In recent years, in the domestic mortgage market, we had seen the growth in ‘self-certification’ mortgages. These are mortgages underwritten by the statement of the borrower that they had told the truth in their statement of income on the loan application. Needless to say, there was a certain degree of exaggeration of income in this process. That didn’t matter to the average lender. In a strong housing market, the increase in property prices would underwrite the veracity of the income statement through the collateral of the property. As the property market has stuttered and fallen, these mortgages have been withdrawn. Self-certification mortgages are now rare birds.

Instead, lenders now resort to the accounting history of the prospective borrowers. This is not without hazard. In the background, there is a debate quietly raging between ‘Principle Based’ accounts – mainly used in the UK and Europe – and ‘Rules Based’ accounts – mainly used in the US. Rules based accounting had been gaining the upper hand until the case of Enron. The Enron accounts had satisfied the rules based accounting principles, but not the principle based accounting rules. This difference between the two is one of those obscure and arcane accounting issues that are likely to dominate our world in the next decade.

On Friday, the Lloyds Banking Group lost a third of its share value because the board of Lloyds did not fully grasp this point (see report). Lloyds had previously been lent on by the UK authorities to absorb HBoS, a large UK mortgage bank that had pretensions to become a more general corporate lender but failed to do so. It appears that the board of Lloyds relied upon a set of accounts produced by HBoS, and had not conducted full due diligence in pricing the merger. Laying aside the wisdom of this, the veracity of the accounts is worth considering.

From Parliamentary evidence last week (see report) it seems that the Head of Risk at HBoS at the time warned the Board that he felt that the bank was taking excessive risks in their lending. His reward – according to his version of events – was to be made redundant. He wrote to the audit committee, who then asked the auditors to investigate. The auditors investigated the claim, and found that the claims were unfounded. Three years later the bank went bust. What is called into question is the role of the auditors in the production of the accounts.

If lenders are to rely upon accounts, those accounts must provide a true and fair statement of the financial position of the entity. There are now calls for reform of the audit process. In particular, three reforms come to mind. First, there is the issue of the automatic rotation of auditors every three to five years to prevent the development of a cosy relationship between the auditors and the management upon whom they are auditing. Second, there is the issue of limited auditor liability. At present there are moves to cap auditor liability for mis-statements on the face of accounts. This trend is likely to be reversed. And thirdly, there is the issue of Chinese Walls within audit firms. Many allege these not to exist. To assure the probity in the production of accounts, there is likely to be a trend towards the banning of audit firms providing consultancy services to those entities that they audit. These trends could well come to dominate the corporate landscape in the coming decade.

When we return to the original question, one of the reasons that the banks are restricting their lending is because they cannot quite trust the accounts that are put in front of them. As the recession bites and asset values fall, the valuation of collateral is likely to become a key issue and the independence of the accounting profession is central to this. It would seem that the world needs the accounting profession to become a bit more disagreeable in producing accounts over the next decade or so. Once confidence in financial statements returns, a more general business confidence will follow.

If not, the business of lending is likely to remain a bit like buying a pig in a poke. You will not be sure of what you are getting in a transaction, which will serve to keep credit conditions tighter than they otherwise would have been.

© The European Futures Observatory 2009

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