US banks have started reporting profits, even repaying some of the funds given to them by the government. But, as Nobel Laureate Paul Krugman points out, a bank’s profits aren’t really hard numbers, since a great deal depends on how much money the bank sets aside to cover the possibility of future losses. As Citigroup’s $1.6 billion first quarter profits show, there is quite a lot of elbow room for massaging the numbers. Around $700 million of the bank’s revenues came from selling off its remaining stake in the Brazilian credit card firm, Redecard. Another $250 million were released from reserves, and $110 million came from a tax rebate. But most important of all, and perhaps shocking, was the $2.7 billion boost to revenues from an accounting rule that allowed Citigroup to buy back its debt at a lower price. US Financial Accounting Standard 159 says that when a debt declines in value, banks have to assume they bought the debt back and retired it. Since the notional buyback is at less than sticker price, the bank has now made money on the deal!
Then there is the case of Bank of America, whose net income rose to $4.25 billion in the January-March quarter, from $1.21 billion a year earlier, only to find its stock price fall by a staggering 24 per cent. That is because investors realised that out of the total increase, $1.9 billion came from the bank’s sale of its stake in China Construction Bank, while another $2.2 billion came from the fact that some of the Merrill Lynch debt fell in value (long live FAS 159!). Similarly, as Dr Krugman points out, Goldman Sachs changed its definition of a quarter so that (in Dr Krugman’s words), “the month of December, which happened to be a bad one for the bank, disappeared from this comparison”. JPMorgan Chase has also reported better numbers, using FAS 159.
In other words, the sharply improved performance figures that the big banks have been reporting in recent days are the result of accounting fiction. None of it represents cash in the bank. As the impression spreads that banks and other companies are using flexible accounting standards to overstate their profits, or under-report their losses, investors and others will stop trusting the data, and keep scanning the numbers for more accounting fiction. When banks put out their data, people will want to examine them with a microscope before coming to a view on what exactly has happened. In short, this is a fresh credibility crisis for the battered financial system. It gets worse if it turns out that Goldman Sachs has paid out handsome bonuses (said to be equal to or more than earlier) on the strength of such accounting.
Much of the blame for this has to be laid at the US government’s door. Pressured by banks and companies that are in trouble, the authorities have relaxed accounting standards in different ways. In India, similarly, the government has relaxed the AS11 standard on accounting for foreign exchange losses; when companies make profits on forex movements in one direction, they use AS11 to their advantage, but when forex movements start hurting financially, the government obligingly defers the application of AS11. This is no way in which to restore credibility to the financial system, in either the United States or here in India.