Europe’s accounting rules are destroying its banks

Mar 13, 2013, 06.14AM IST
(Banks may have systematically…)

By Gordon Kerr

Late last year, a group of institutional investors sent a letter to officials in Brussels, warning that European Union accounting standards are "destabilising banks" and "damaging national economies." Accountancy may rhyme with geeky, but the investors were right and addressing the issue they highlighted is essential to restoring Europe's financial health.


The rules concerned are called the International Financial Reporting Standards, and they're used across the EU and in a growing number of other countries around the world.

The potential misreporting involved is significant. In the case of just one UK bank, Royal Bank of Scotland Group, I and others calculated that IFRS rules resulted in the bank understating its 2011 losses by £19.5 billion, or roughly twice the UK taxpayer bill for the 2012 Olympic Games.


If this is correct, then the state's £45.5-billion ($67.7 billion) bailout of RBS in 2008 and 2009 was calculated against a balance sheet that probably also flattered to deceive. The risk of such faulty numbers is clear: If RBS fails to recoup this hole in its accounts through genuine profits, then the UK taxpayer may be on the hook for £20 billion more than the government bargained for. Last week, RBS reported a larger than expected loss in 2012 of slightly less than £6 billion.

Like the US generally accepted accounting principles, better known as GAAP, Europe's accounting standards are detailed guidelines for the presentation of financial information. Just as governments publish manuals on how to drive a car safely, so they have encouraged the production of accounting guidelines for financial reporting.

The legal impact of the guidelines differs widely in the two scenarios, however. Driver's manuals are nothing more than that, manuals, which no court would substitute for the law. If a driver starts to brake at the correct distance from a stop sign, but still fails to stop, it is no defence to have followed the manual — he or she broke the law. Under European accounting law, following IFRS standards is a defence and the guidelines have been allowed to override national laws. The rule that concerns investors the most restricts provisioning against expected future loan losses. Under IFRS, loss provisions can only be booked (thus reducing this year's profits) if a loan event, such as a default, has occurred. The US rule-makers who oversee GAAP have refused to follow the IFRS in this. Talks aimed at converging US and EU expected- loanloss accounting rules ended without result last July.


(Gordon Kerr is the founder of Cobden Partners and the author of "The Law of Opposites: Illusory Profits in the Financial Sector.")