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Banks Are Impossible For Anyone to Understand

Banks Are Impossible For Anyone to Understand

Monday, 23 December, 2019 - 08:00

A simple lesson we should have learned from the financial crisis is that complexity begets abuse, and undermines stability. Yet the key measure we use to determine banks’ health is so fiendishly difficult to understand that outsiders have no choice but to accept what we’re told by the lender.

That’s the conclusion of a broad UK government review of the audit industry unveiled this week. Donald Brydon, the former chairman of London Stock Exchange Plc who ran the review, considered whether accountants should be brought in to verify how banks calculate the all important “risk-weighted asset” measure. Alarmingly, he concluded that there was no point because even trained auditors would struggle to get their heads around these calculations, unless banks employed an army of them. If that’s true, then what hope for ordinary shareholders or bank supervisors?

After all, we’re talking here about the figure that lenders and their regulators use to assess how much capital they need to hold against the risks they’re taking. Worries about divergences in how banks work out risk-weighted assets have already prompted new rules to limit the degree to which they can use their own models. The world’s leading financial regulators have urged the audit profession to help , as has the Institute for Chartered Accountants in England and Wales.

Unfortunately, Brydon believes that getting auditors involved is simply not viable. Tucked into his 138-page report, the City grandee concludes that because the models on which risk-weighted asset calculations are based “can run to many hundreds of pages of explanation,” getting auditors to provide opinion on their truth and fairness would "involve a disproportionate additional cost.”

And at a practical level, “the depth of skills necessary to undertake such separate assurance are not obviously widespread and readily available,” in the accounting profession, says Brydon. His alternative solution is to get the U.K. banking supervisor, the Prudential Regulation Authority, to issue a letter of comfort as it already reviews the banks’ risk-weighted asset models. But given his admission that this task is beyond the audit profession, it’s not clear why just writing a letter would make bank calculations any more transparent.

Moreover, Brydon’s conclusions beg a number of questions. Isn’t the complexity of risk-weighted calculations precisely the reason they should be reviewed externally? If auditors lack the skills, where else is the expertise? Ultimately, shouldn’t we be striving to make these fundamental measures accessible to a wider pool of experts? How can we trust that banks are as safe as they claim to be, and aren’t just gaming the system?

This year alone there have been a number of examples of dubious risk-weighted asset calculations. The UK’s Metro Bank Plc is being probed by regulators for assigning a weighting that was too low for some assets, an error that — once fixed — led to the bank raising capital. Citigroup Inc. was fined in Britain for inaccurately reporting its capital and liquidity in part because the firm underestimated its risk-weighted assets. Most recently, Coventry Building Society, a UK lender, corrected risk weights that inflated its financial strength for years. (The firm was still comfortably above regulatory requirements).

While none of these incidents has threatened the viability of any one company, let alone the financial system, institutions are tripping up on an essential reporting requirement that’s too complicated to unpack. As regulatory failings go, this one might easily have dangerous consequences.


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