Regulators fight for ‘clean’ information

The comparison is unduly frivolous in many ways but nonetheless fitting.

Sometimes there is a measured, chess-like quality to the proceedings, complete with cunning gambits and uncanny anticipation. At other times there is all-out hostility, with blows landed and casualties recorded. Invariably, regardless of intensity or fanfare, there is an element of what Marxist philosopher Antonio Gramsci described as a “war of position” – a drawn-out, frequently unseen battle for influence and power.

It is now nearly 15 years since the collapse of Enron exposed one of the biggest financial reporting and auditing failures in history. It seems inconceivable that the firm was once lauded for its corporate governance and risk management, earning praise, admiration and a slew of awards – including no fewer than six under the banner of America’s ‘most innovative company’.

Then again, Enron certainly was innovative. When the firm finally fell apart, the mind-boggling extent of its farsightedness and ingenuity could be appreciated in full.

It transpired that the meteoric rise from nowhere to corporate titan had been substantially underpinned by creative mark-to-market accounting, special-purpose entities and assorted other acts of bookkeeping wizardry designed to facilitate financial statements blessed with increasingly scant relation to reality.

Though undoubtedly an extreme case, Enron highlighted in spectacular fashion how the necessary faith that investors and shareholders habitually place in financial reporting can prove misguided.

The unfortunate truth is that annual reports and other facts and figures can be manipulated and misrepresented in all manner of ways, usually to the disadvantage of those who rely on them for transparent and ‘clean’ information.

RBS provides a more recent illustration from the investment world. In 2010, the bank was able to overinflate its own worth by as much as $25bn (£15.8bn) by applying International Financial Reporting Standards (IFRS), the terms of which permitted it to keep the risks in its loans hidden until those loans defaulted.

An FSA (now the FCA) report later conceded: “Anticipation that large loan loss provisions [LLPs] might arise was highly relevant to the collapse in confidence in RBS in autumn 2008. The perception of relatively poor loan quality was confirmed post facto by the scale of RBS’s provisions in 2009 and 2010.”

The manipulation of LLPs is now firmly in the regulators’ sights, not least via the gun barrel of Basel III. Yet it is well worth remembering that IFRS was introduced post-Enron in an attempt to encourage less subjective accounting practices.

Thus a presumably well-intentioned bid to prevent a repeat of one debacle led to another, one in which banks – that were suddenly required to report distressed loans only upon default – could disguise the build-up of risk.

The Basel Accords are now more than 25 years old. All have been part of the “war of position” – strategic responses to institutions’ growing adroitness in structuring their liabilities and assets so as to circumvent legislation.

Basel I, which laid the foundations for bank solvency around the world, was quickly found wanting as markets grew in complexity in the 1990s.

Basel II, which followed almost a decade of painstaking negotiations, failed both to support the effective operation of market forces and to ensure the costs of regulation were proportionate to the levels of risks banks were running.

So what hope for Basel III, which – perhaps unsurprisingly – was in large part thrown together in just more than a year? Experience should temper expectation.

The thorny and currently fashionable issue of LLPs may well be successfully addressed, and investors and shareholders may one day be presented with much ‘cleaner’ information. But the nature of the game dictates that the question of transparency will be shifted elsewhere and the wider, seemingly eternal fight for supremacy will continue to unfold.

What we are left with is a state of permanent tension. Both sides will go on enjoying triumphs and suffering setbacks, but it is highly unlikely there will ever be an outright winner.

Perhaps the main point institutions and regulators should keep in mind is that there should be no outright losers. As has been witnessed many times, investor and shareholder confidence based on false information is unsustainable.

Dr Robert Webb is an associate professor of banking at Nottingham University Business School and a member of its Centre for Risk, Banking and Financial Services