“Financial institutions could fictitiously show a profitable and happy world. For a while at least. In these lines we explain how”

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ARISTÓBULO DE JUAN, FORMER DIRECTOR GENERAL OF INSPECTION AT THE BANK OF SPAIN | Once upon a time there was a financial system that appeared to be in good health. Everyone knew how important banking was for a country. For it was the conduit of the payment system and the transmitter of monetary policy. It was also the repository and manager of the country’s idle resources and the channel for their proper allocation. Its good health was therefore fundamental for the economy and for employment. Precisely because of its importance, banking required the existence of official control in the form of a regulatory framework to ensure its good health and proper functioning. This framework implied public responsibility, which was not always recognised. It had to be composed of three complementary pillars implemented with political will. The pillars were regulation, supervision or inspection and the treatment of insolvency situations. All of this was complemented by external audits, whose public reports would be a basic reference for the proper functioning of the market. This framework was to ensure a strong financial system, i.e. “safe and sound”, in Anglo-Saxon terminology. The enemy of these mechanisms was the lack of transparency of many institutions, which could mask their problems, thus preventing them from being dealt with in a timely and preventive manner. As a result, the institutions themselves could fictitiously portray themselves as a profitable and happy world. For a while at least.

And what were the mechanisms that prevented the transparency of reality? The Anglo-Saxons say that “there are a thousand ways to skin a cat”. This story attempts to describe the most frequent practices to achieve that goal. The most effective masking, due to its difficult verification and its large volume, would be the refinancing of bad loans, formalising generous grace periods in favour of the debtor. It would always be possible to refinance the principal of the debt. But the refinancing of interest could take two forms. Either by deferring their payment, in parallel with the principal, or by the lender financing the debtor so that the latter would “pay” the lender with the same funds. This fictitious payment was unduly recorded as income. This practice was surprisingly validated by the external auditors. Other forms of “creative accounting” could also be practised. One of them could be the accounting deconsolidation of bad assets and expensive liabilities. By transferring them to special purpose vehicles of their own. They could also deconsolidate large packages of bad loans and fixed assets to newly created special purpose vehicles, but in partnership with a major hedge fund, to which they would grant a majority shareholding to “justify” the accounting deconsolidation. In fact, if this were the case, the risk would not really be segregated, since it would be agreed to compensate the Hedge Fund for any losses caused by the sale of the asset at a lower price than the acquisition price.

“International regulators had devised a resolution mechanism that cost them nothing, not a blush. Charging the costs to shareholders and investors who lacked reliable information”.

Another practice that could encourage opacity could be the use of a network of companies of their own incorporated in foreign countries – off-shore or not – as a conduit for loans ultimately destined for problem customers. Opacity could also be achieved by granting cross loans to customers through other institutions, thus avoiding the control of a possible concentration of risk. As a parenthesis, let us remember something important here: the three pillars of the regulatory framework had to be of high quality at the same time, because if one pillar failed, it would render the others useless. For example, if the regulation was flawed or tolerant, it would render supervision ineffective and thus impede the treatment of insolvency.

As an example, this story captures some of the weaknesses in the regulations that could potentially hamper or render supervision unusable. The regulations could establish erroneous or lax criteria for the valuation and classification of assets, thus avoiding the necessary provisions. The accounting results and the reserves fed with them would not be real. The same would be true if the rule left provisioning to the discretion of institutions, rather than making it mandatory. The rules could also allow items with no economic substance to be counted as a component of the regulatory capital requirement, for example tax credits or bad will. This is the difference between the price paid for an acquired bank and its book value. The regulations could also tolerate “buyback”, the repurchase by institutions of large blocks of their own shares on the market. This practice could artificially raise the stock price and reduce the volume of capital. But it increases the value of the remaining shares, including those of the owners of controlling stakes.

In real life, the laxity of these rules “legalised” bad practices, as they no longer violated them, because they took internal information and risk assessment by the institutions themselves as good. The necessary application of corrective measures in a timely manner that could prevent greater evils was seriously hampered by the rules themselves. This allowed the institution to gradually fall down the “slippery slope” and reduced supervision to the analysis of information that was far removed from reality. Perhaps the most serious aspect of this imaginary scenario is that the supervisor’s diagnoses and actions were almost always useless because they were based on information from inside the supervised institution. It is internationally known – though not always recognised – that healthy institutions are transparent, but those with serious problems hide them.

Therefore, as computer scientists say, “even if the computer is flawless, if it receives rubbish, it produces rubbish”. In other words, the analysis of inside information, without proper verification, leads to erroneous and logically counterproductive conclusions. This is because it prevents timely corrective action and delays the handling of insolvency by increasing its costs, perhaps exponentially. It is important to note that the scenario described above would allow unprovisioned non-performing assets to be kept “legally” on the books. These constantly give rise to new current losses because they do not generate income but carry the costs of financing such assets. This issue is often ignored. It could be the case in this story that, even under the circumstances imagined, institutions could distribute large profits and reward many of their managers with large emoluments, both salaries and incentives, as a reward for “good” management. Dividends – even if they were in the form of scrip dividends (i.e. in the form of shares) – meant an outflow of real cash flows calculated as a proportion of profits that could be largely book-entry. Therefore, such behaviour, if it occurred, would be damaging to the bank’s capital. Real cash flows were outflows fed by book entries only.

“Perhaps the most serious aspect is that the supervisor’s diagnoses and actions were almost always useless because they were based on information from inside the supervised institution. When it is internationally known – but not always recognised – that institutions with serious problems hide them”.

The bad news is that the scenarios described in this story could have been facilitated or exacerbated if they had occurred in the context of a supervisory philosophy that prioritised supposed stability over the strength of the banking system. Perhaps to avoid the trauma of dealing with potentially systemic problems. This philosophy, if it existed, could be embodied in one or more criteria, inspiring the so-called “regulatory forbearance”. Supervision could be conceived as helping banks rather than addressing their problems or changing bad managers. It could be argued, as a defence by bad bankers, that supervision should avoid the “intrusion” that verification of information, accounted for by the banks themselves, would entail. Such a philosophy would consider that it is not the problems of the present that are important, but those that could be estimated for the future. It does not take into account that problems that are not dealt with get worse. The best oversight mechanism, according to this philosophy, would be to ensure good governance. But this laudable objective is of questionable effectiveness, given the poor information that used to be available to boards of directors, even in the most orthodox banks.

This story could end here. But if the assumptions described here and their repercussions on the financial system in question were to occur, which of the actors would be to blame? And who should pay the price? It is clear that the owners of the majority stakes in the banks in crisis and their managers are primarily responsible and must suffer the consequences. On the other hand, minority shareholders and investors would not be responsible, since they never received reliable information about the situation of the institution. Would it be logical – even ethical – that, having taken their decisions with bad information, tolerated by the supervisors, they should pay the price? What I have no doubt is that the supervisors – of banking and securities, national and international – would have sinned by omission, incurring in the figure coined by Roman law of “culpa in vigilando“.

By their tolerance or passivity they would have failed in their public responsibility to ensure the health of the financial system. It would seem logical that they should also pay the price. Or part of it. The auditors, whose clean reports do not usually reveal the auditee’s problems, thus misleading the investor market, would also be jointly responsible. But in this story, international regulators had devised a resolution mechanism that placed all the costs of the clean-up on the resource providers, shareholders and investors. They lacked reliable information. But it would be worse if the hypothesis – perhaps far-fetched – of the wrong-headed were true. Because they do not rule out that this mechanism is a tacit incentive for supervisors to relax their controls in the hope that insolvency will manifest itself in irresistible illiquidity and trigger a resolution that will cost them nothing. Not even a blush. If this were the scenario, the local wise men would advocate a thorough reform of the regulatory framework in place there to avoid dramatic scenarios that might be avoidable.

About the Author

The Corner
The Corner has a team of on-the-ground reporters in capital cities ranging from New York to Beijing. Their stories are edited by the teams at the Spanish magazine Consejeros (for members of companies’ boards of directors) and at the stock market news site Consenso Del Mercado (market consensus). They have worked in economics and communication for over 25 years.