The Bracken column is named after Brendan Bracken, the founding editor of The Banker in 1926 and chairman of the modern-day Financial Times from 1945 to 1958.
During the past two years, investors have faced one of the most challenging environments in living memory. When confidence in banks falters and markets crash, equity and debt investors are left asking: what will aid recovery and help prevent another crisis? We would argue that changes to financial disclosure and reporting are required. Specifically, investing in banks continues to be complicated by inconsistent accounting rules, fragmented regulation and less confidence in management to deliver.
It used to be that banks were allowed to 'smooth' profits, by increasing provisions for future losses during the good years, and reducing them in the bad. Assets were largely valued on an accrual basis rather than fair or market value.
International Financial Reporting Standards all but brought an end to this from 2005. For banks, the revolution was the concept of fair value accounting for a far broader set of assets. The sweetener was that the adoption coincided with increasing asset values. The three new categories of assets - hold to maturity, available for sale and trading - saw the latter two valuing assets at market prices. At the time, there were solid philosophical arguments in favour of banks being assessed on a 'truer' market value of assets basis. Transparency may optically have improved, but comparability was still blurred by different asset categorisations.
Now, just as asset prices hit bottom, mark-to-market accounting has itself gone out of favour. In Europe, the International Accounting Standards Board is planning to re-introduce accrual accounting for a wider range of assets in order to make banks' asset valuations less leveraged to the overall market. The US Financial Accounting Standards Board is apparently considering similar moves.
Statements made during the G-20 meetings in London also confirm a move towards greater counter-cyclicality.
As investors we wish for a clear set of accounting policies consistently applied within and across borders, as well as through economic cycles. While we welcome the debate about the relative merits of a mark-to-market approach, it is arguably more important for us to have one set of accounting principals that last. The frequent changing of recent years has obfuscated the analytical process. We would also argue for a far greater globalisation of accounting standards to move comparability forward in a real way.
The regulatory backdrop
Away from pure accounting, the Basel II international regulatory framework also presents challenges for bank investors. While this more sophisticated risk-based system arguably provides a more appropriate and efficient way of measuring capital requirements, we have the following reservations:
Lack of transparency: Under the internal ratings-based approach to risk-weighting calculations, capital ratios, as measures of financial strength, have become more opaque and less useful. The denominator - risk-weighted assets - is largely based on internal models not available to the investor.
Comparability: Application of the framework by institutions and regulators has been slower and more conservative than hoped for. This makes it extremely difficult to compare one bank's performance to another. For example, calculations of the probability of default, which is influenced by historical observations, have resulted in disclosure which currently suggests that the risk weighting for a Swedish mortgage is lower than a similar Norwegian mortgage. While this may be historically accurate, it does not reflect a 'true' picture of current conditions, such as relative gross domestic product growth and unemployment expectations.
We would like to see a much stronger role for international macro-prudence to help equalise national regulators' interpretations of international capital rules, and encourage investment.
Rebuilding trust
As any investor knows, financial statements alone provide an incomplete picture of a bank's performance. The events of the past couple of years have certainly tested our faith in bank management teams and challenged us to review how we evaluate management's performance, good governance and remuneration structures. Specifically, what information is required to give us a better insight into what goes on behind boardroom doors? What indicators will demonstrate if management has clear oversight of risk? What reported data will allow us to assess if remuneration is aligned with strategy, performance and risk exposure?
As a first step, we would like to see the banking sector seize the initiative to drive comprehensive and effective remuneration reform, rather than having constraints imposed from outside.
From an investor's perspective, our requirements for consistent, comparable financial information appear to be provoking some positive responses. We are encouraged by recent proposals set out by the G-20 and the Bank for International Settlements which focus on a more global approach to regulation and accounting measurement. We also welcome moves to force banks to increase capital and reduce leverage in order to ensure a greater cushion, long term, against inappropriate risk-taking and severe market fluctuations. We want enough capital to ensure stability over sustained periods, but which avoids inefficiency.
However, we fear that over the coming months and years the political climate could change and the financial market's famously short memory could cause us to return to parochial, inconsistent accounting, fragmented regulatory policies and the skewed remuneration practices that helped create the crisis. Let's not go back to the future again.
Paul Allen and Paul Fenner-Leitao (Senior Credit Analysts), Kirsty Jenkinson (Director, Governance & Sustainable Investment) and David Moss (Director, European Equities) are all employees at fund manager F&C Investments
