Cause of the Crash #39

29 September 2010

Sarah Wilson

The BBC's Robert Peston has picked up on founding FSA chairman, Howard Davies' critique on the causes of the Crash. According to Davies there were a total of 38 reasons. Peston goes on to argue that there were probably 39 if you take into account the proposition forwarded by Tim Bush, former fund manager for the Hermes Focus Fund and member of the Urgent Issues Task Force of the Accounting Standards Board (ASB) that is was untested accounting standards which undermined prudent bank financial governance.

Bush's arguments are both complex but also straightforward at the same time. Peston sums it up very neatly though:

In simple terms, what went wrong - Bush says - is that in the UK and Ireland from 2005 onwards banks stopped making any general provisions against the risk that their loans could go bad. In that sense, they stopped the long and tested practice of factoring into the cost of a loan the probability that it might not be repaid.

British and Irish banks stopped making these provisions for possible non-repayment of loans at both the level of published accounts and at the lower level of the operating units.

This was not their choice, Bush says. They were forced to do it by the way that the Accounting Standards Board implemented the international accounting standard IAS 39 as Financial Reporting Standard 26, or FRS 26.

Bush argues that the implementation of FRS26 magically made lending seem less risky and cheaper for British banks - so (guess what?) they did much more of it.

If you look at the terrifying speed at which Northern Rock increased the supply of 100% mortgages, or the extraordinary acceleration of lending to property companies by HBOS, there would seem to be some connection between the worst excesses of the UK's credit bubble and the cessation of any requirement to factor in the probability that some loans would go bad.

And there is a similar correlation between the accounting change and the timing of the explosion in property lending by Anglo Irish Bank and Allied Irish Banks.

The nub of Bush's thesis is that accounting standards and good corporate governance have been on a collision course since the introduction of FRS 26. As he argues in his response to a recent ASB consultation, FRS26 can be applied to circumstances which contravene the UK Companies Act requirements that companies - and especially banks - operate in a prudent manner consistent with the protection of their depositors and crEditors. Bush, Yorkshire-educated and never knowingly indirect, credits the breakdown in accounting prudence with having created a global Ponzi scheme. (For non-British readers an explanation is required - Yorkshire is the English county associated with blunt speaking, hard headed and intractable speakers who are unfailingly honest.)

From a shareholder's perspective, as Peston puts it "shareholders might be able to claim that they were gulled by FRS26 into believing that Britain's banks were made of bricks when they were in fact made of sand."

Howard Flight, former Shadow Chief Secretary to the Treasury and Deputy Chairman of the Conservative Party has thrown his support behind Tim both on his blog page and also as co-signatory to letters in the British media. On that basis we could expect this to be picked up at next week's Conservative Party Conference.