What a difference a year makes in great banking clean-up

Regulators still facing a number of challenges as they unveil plans for next phase of strategy

Regulators still facing a number of challenges as they unveil plans for next phase of strategy

BANKING REGULATORS in Denmark have adopted a novel approach to understanding whether their banks have valued their loans accurately. They leave their desks for random visits to inspect the properties supporting those loans.

Such approaches have pricked the interest of the Central Bank’s banking supervision team as it continues to overhaul a regulator cited as a major cause of the €70 billion Irish banking meltdown.

A year after publishing its strategy for banking supervision, the Central Bank yesterday issued an update on its progress so far and plans for the next six months.

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The idea of Irish regulators cycling around Dublin suburbs viewing properties is not contained in the report but it does identify key areas of focus – addressing how quickly banks book expected losses and pay executives, and improving the quality of financial statements and credit standards at the banks.

Had banks taken larger provisions for loan losses earlier, it is possible the bill to the State to meet losses would have been lower, the Central Bank says. Accounting rules meant that the banks could only book a loss once the loan went bad under the “incurred loss” model. The Central Bank wants a move to an “expected loss” model.

The recent €24 billion capital bill set for the banks following the stringent stress tests last March will leave the lenders “over-capitalised”. This will give them the flexibility to report higher losses.

“The cheque has been written to cover those losses but rather than dripping out those losses, you have to recognise those losses as quickly as possible,” said Dwayne Price, deputy head of prudential analytics and resolutions in the banking supervision department.

The Central Bank is pushing for banks to recognise the expected losses in the stress tests to cleanse bank balance sheets once and for all, and disclose the clean-up clearly to the markets.

This is to ensure that “financial statements are prepared on a more conservative, prudent and consistent basis that, over time, will enhance trust in Irish banks’ financial statements,” it says.

Blackrock, the independent consultants hired by the Central Bank, noted that Anglo Irish Bank had gone further than the other banks in terms of writing down loans.

Anglo and Irish Nationwide, whose bailouts stand at €29.3 billion and €5.4 billion, were the only lenders that did not require further capital after the stress tests.

But the other four – Bank of Ireland, AIB, EBS and Irish Life Permanent – still have further to go when it comes to acknowledging the losses in their books.

Price says it “doesn’t make a lot of sense to have a big gap” between how the losses are reported in the banks’ financial statements and the expected baseline losses in the stress tests.

How this gap is to be bridged will be addressed by the Central Bank, working with the accounting bodies, with a view to the residual losses being recorded in the banks’ 2012 accounts.

That year’s financial statements are likely to feature higher losses anyway, not just on bad loans but on the deleveraging of the banks as they shed loans and others assets to return to self-sufficiency.

“We need to bring to a head an issue that still stalks the banks – how bad are the underlying loan portfolios, particularly where there is forbearance going on,” said Jonathan McMahon, director of financial institutions supervision at the Central Bank.

“The aim is to flush out the bad stuff on the loan books. You try to do that in one go so you are not dribbling out bad news.”

McMahon describes this as “the final step” to get clarity around the reality of what is still in the banks.

While this may throw up difficulties for auditors trying to grapple with forecasting losses on loans, the Central Bank believes it will not prevent the changes. “It is not obvious to us that the obstacles are insoluable,” said McMahon.

The Central Bank has been critical of the accounting bodies being narrowly focused on backward-looking audits rather than flagging the mounting potential risks to property lending within the banks.

“I am not completely sure that they have done as much as they could have done,” said McMahon.

Should the banks or auditors refuse, the Central Bank can force the banks to recognise losses. “We hope this will be occur voluntarily, but ultimately we are willing to compel a solution,” he said.

The Central Bank has also noted that there is a significant variation across the banks on how they deal with distressed borrowers, which is also affecting the level of provisions at the banks. “One is particularly slick and the others are playing catch-up,” said McMahon.

A new credit register and valuation standards for loan collateral – for the most part property – will help establish a single approach to valuing loans that should reassure investors in their understanding of risk in Irish banking.

This will prevent a repeat of past mistakes where the banks did not have a full picture of the indebtedness of their biggest borrowers across all of their banks.

The Central Bank also plans to revisit bankers’ pay now that it can apply sanctions following the passage of European Banking Association guidelines.

The focus will not be on how much bankers are paid but how their pay is measured so that cash isn’t doled out to staff for recklessly growing loan books without due regard to the long-term performance of those loans.

“We will be checking to see are the banks paying people in a way that is effective in their stewardship of risk,” says McMahon. “It goes to the heart of the culture of an institution how quickly they engage on this.”

As for the resources applied to regulation, the headcount in the Central Bank’s banking supervision department has increased from 100 to 140 in the past year.

Where, for example, a three-person team supervised Bank of Ireland and Anglo Irish Bank during the boom years, there are now eight supervisors monitoring each of the main banks. They are supported by the new prudential analytics and resolutions division.

The banking supervision team is also cherry-picking the best regulatory practices in other countries and has looked to how banks regulate in Canada, Australia, Singapore and, most recently, Denmark.

“People have looked in the mirror here at what went wrong,” said McMahon. “But we are looking ahead too at what is being done internationally and what we can take from that.”

Simon Carswell

Simon Carswell

Simon Carswell is News Editor of The Irish Times