Banks using tricks to give their finances a facelift

The majority of Greek investors are puzzled and some senior bankers are vociferously complaining that the stock market has been treating their banks unfairly, as their earnings have been going up at the same time that their shares have been moving sharply down. It looks as if they are not the only ones puzzled. Some other senior bankers say in private that they are also puzzled for another reason. Namely, the inability or unwillingness of stock analysts to explain how banks – which are facing a steeper rise in funding costs compared to the interest they earn on their assets, namely loans – can continue to report earnings growth during the current period. According to these bankers, the solution to the second puzzle should help investors and others solve the first puzzle. «All this is driving me crazy. The cost of funding has gone up on average by 75 basis points in the last 12 months, and banks have been able to pass on only 25 basis points to their customers,» says a top official at one of the country’s largest banks. «How can serious analysts accept this at face value? The only explanation I can give is they want to hear good news and accept any guidance provided to them by certain banks.» In effect, what the maverick banker is claiming is that some local credit institutions have been using all available accounting tools at their disposal to «dress up» their financial results at a time when economies, including the domestic one, are slowing, inflation is rising and the global credit crunch is not receding. What are these tools? First, the favorite of selling real estate assets and/or gleaning one-off revenues from treasury operations in bonds, foreign exchange and to a lesser extent commodities. In this way, banks have been able to beef up their earnings and make up any earnings shortfalls from core operations. However, the sorry state of stock and bond markets has not helped banks much so far this year. Trading revenues are sharply down compared to the same period one year ago or the last quarter of 2007. Second and most important, according to this banker, is the introduction of Basel II and so-called impairment tests used by banks to determine the right provisions for their loans in arrears beyond 90 days. It is worth noting that the Basel II accord is a set of recommendations about how much capital banks are required to set aside to guard against different types of risk in lending and investing, issued by the relevant committee of the Bank for International Settlements (BIS). Greek bankers have been saying all along since the start of the global credit crisis that there are no signs of deterioration in the credit quality of their loan portfolios, either corporate or retail. However, they hint in private that some banks use the impairment tests in such a way so as to minimize provisions for their loans in arrears in order to boost their profits. Some suspect they do so because they want to help boost their stocks in a difficult market environment. Some add that they do so with an eye to an M&A deal, looking to improve their position at the negotiating table. Whatever the case, it is very difficult to ascertain what is really going on. Only the people in a bank are fully aware whether the size of provisions made is appropriate or not. «The subjective factor prevails when it comes to impairment tests and provisions can be manipulated,» says the maverick banker. Another top official at a large bank implies more or less the same. «If one compares each bank’s provisioning policy with that of its competitors, one may find interesting things. For example, a bank’s annual earnings may be 200 or 300 million euros lower than reported if it followed a more conservative policy,» he says. Still, all agree that this does not mean these banks have been doing something illegal. After all, what they are doing is compatible with IFRS accounting standards and approved by auditors. Even so, bankers admit that auditors must have extensive knowledge and be willing to go deep into the books, and this is often not the case. Assuming these bankers are right and some banks understate their true level of provisions for loans in arrears beyond 90 days in order to boost their profits, it should come as no surprise that this has weighed on their stock performance in addition to the de-rating in the financial sector globally and the general investor risk aversion for banking stocks. This may help solve the puzzle as to why Greek and Cypriot banks have seen their shares fall by between 56 and 23 percent from their 12-month highs at the same time that their earnings have been cruising at a speed of 69 to 294 percent (cumulatively) since 2005.