AUDITING BANKS’ TOXIC DEBTS

Ever since the financial markets registered their massive tumble in 2008, when Lehman Brothers was left to drown in its swamp of toxic debts, banks’ managements, regulators, rating agencies and auditors have been muttering that banks must rebuild their balance sheets in line with successive Basel capital adequacy criteria.

Their auditors, alone among these guardians of financial propriety, carry primary legal responsibility for conveying the news, good or bad, on the reliability of banks’ accounts. Yet the auditors of banks are subject to the same tension of conflicting aims as any auditors – to maintain audit quality without making too many waves. All the efforts of the Competition Commission to preserve competitiveness have done nothing to resolve this tension, itself a product of our obsession with independence as the cornerstone of audit integrity.

There was a time when companies’ Articles stipulated that their auditors should hold a minimum level of “qualification” shares; unthinkable now, when the idea of aligning the interests of management and auditors is anathema.

Delivering audit quality

So how to guarantee quality? Take the vexed issue of auditing the extent of erosion in bank assets. The default matrix is to exercise just enough rigour to demonstrate the robustness of the exercise, but not so much that the emerging picture runs the risk of spooking the entire edifice with the spectre of huge capital deficits. It’s a delicate balance, fraught with an immeasurable amount of subjective “judgement”.

It’s a delicate balance, fraught with an immeasurable amount of subjective “judgement”

Consequently, the level of dross that remains in any bank’s loan portfolio is nothing more than inspired guesswork; and on published evidence the guessing has been singularly uninspired. The relevant euphemism for duff debt is “non-performing loans” (NPLs) and a recent report from PwC, based on lending banks’ own audited accounts, estimates that the level of NPLs in Eurozone banks’ accounts more than doubled between 2008 and 2012 to reach a magisterial 1.2 trillion euros.

This defies all logic. Surely the level of NPLs would have peaked just before the bubble burst in 2008? Yet despite savage attrition of asset write-downs and bailouts galore, the recorded level of NPLs doubled over the same period. And one year on, PwC estimates that the total of Eurozone banks “non-core” loans stands at 2.4 trillion euros.

Unchallenged assertions

These crazy numbers are derived from “management estimates” that could not have been challenged with objective rigour. How else could each year’s write-offs have mysteriously spawned an even greater crop of NPLs the following year? A veritable Hydra: cut one head off and two grow in its place.

The phrase “non-performing loan”, in ordinary terms, means quite simply that the lucky borrowers got the money, defaulted on (sorry, “renegotiated”) interest payments and capital repayment schedules, while the principal sum remains on the lender’s balance sheet, courtesy of auditors who still believe in fairies – and the validity of mark-to-market valuations (the same thing).

Bizarrely, there is a thriving market in the purchase and sale of these “assets”. I suppose that if an entire book of NPLs is offered for sale at a smidgen above zero there will always be takers ready to send in the heavies to secure a modest return.

But fear not. The European Central Bank is about to take on a shining new role as the Eurozone’s banking supervisor. For this it is, of course, singularly well-qualified, having breached the terms of its own constitution to gain extensive bailout experience, using its own printing presses to purchase sovereign debt. Indeed, it boasts billions of Greek bond holdings on its own balance sheet at their face value – thereby creating the world’s ultimate non-performing loan!