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Market Discipline Requires Honest Accounting

Yesterday I wrote about the iffy credit outlook for Dexia. Today I’d like to write about Dexia as an example of the quality and usefulness of European bank accounting for investors and creditors.

Here are Dexia’s reported earnings for the past seven years (billions in euro):
2006: 2.7
2007: 2.5
2008: (3.3)
2009: 1.0
2010: .7
2011: (11.6)
2012: (2.9)
1H13: (.9)

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Notice anything odd? Dexia reported profits of 723M at yearend 2010, only to be followed by a loss of 11.6B in 2011. Think about that: Dexia’s management and auditors signed off on the 2010 financial statements in March of 2011 and presented them to Dexia’s shareholders in May of 2011, only to report a loss of (oops!) 11.6B for 2011. The same saga was true in March of 2008, when management reported a 2.5B profit for 2007, only to report a 3.3B loss for 2008.

How can management report a profit in the same year that it is heading towards a massive loss? Is that incompetence, or legerdemain?

It is one thing to “manage” the reporting of massive credit losses so that they bleed out over a multi-year period. That enables a bank to match its credit expense with its operating income. Everyone does that, or tries to. But it is quite another to punctuate the recognition of catastrophic losses with periods of reported profitability. Wouldn’t an honest bank consume that supposed profitability with an addition to reserves? If you’re going to lose 12B euro, you might just put that 723M into the provision, as “an overabundance of caution”.

And it isn’t just Dexia. Banca MPS in Italy is the same story: it reported a 946M “profit” for 2010, followed by a 4.7B loss for 2011. Shouldn’t that 964M “profit” have been added to reserves, given what followed?

Why does it matter whether bank financial reporting is truthful? For three reasons: (1) shareholders; (2) bondholders; and (3) depositors. Shareholder bought the shares of these banks in 2007 for high prices, only now to find that they are worth a few cents. Retail investors bought the subordinated debt of the cajas that now constitute Bankia, only to be wiped out. And finally depositors, such as those with deposits in the two largest Cypriot banks, who have been wiped out substantially if not totally.

It is now European policy that depositors are expected to take losses because they “contributed” to the problem. They “contributed” to the problem by irresponsibly placing their deposits with insolvent banks. Had they been responsible, they would have known that these banks’ financial statements were fictitious.

Market discipline depends on honest financial reporting. As long as European bank managements can decide whether to make or lose money in a given accounting period, shareholders and creditors will be stumbling in the dark.

That means that it is only a matter of time until another credit event reveals to depositors in Club Med banks that they have made a big mistake. Can you imagine that Daimler or Siemens or Nestle are likely to leave a lot of money on deposit at Banca MPS or Banco Espiritu Santo for more than about ten seconds?