Are the UK banks overstating their profits?

Some fancy footwork may be causing banks to overstate their profits, and in particular may explain why many banks showed a substantial profit in their fixed income (bond trading/swaps/derivatives) divisions when the rest of the economy is deteriorating. It is all down to what are known as “Own credit CVAs”.

A CVA is a “credit value adjustment”, the mark-to-market a bank puts on a derivative asset or liability. Historically if a bank held an asset or liability, then it held the asset on its books at the same value irrespective of the market price until it made a provision against the asset, and likewise all borrowings were held on the books at the same price.

But then as finance became more complicated and we got into the world of fancy derivatives everything started to be marked to market. If a bank held an asset, perhaps an in the money swap, then the value would be adjusted according to market prices, and if the market price was not easily discernible, the asset would be valued using a proxy such as risk free rate plus a credit default swap margin. As the risk free rate and margins move the asset would be repriced and the difference would be booked to profit and/or loss.

Now the same thing would happen with borrowings, only this time when a bank’s credit spread widens, the discounted value of its obligations goes down in mark-to-market terms, so in those terms it is “better off” and books lower liability and corresponding gain. Think about it. The banks market rating deteriorates, so it books a gain on its borrowings. Of course this results in higher later funding costs – effect of the gain and is reflected in higher future costs.

But still, without actually doing anything, the banks book a profit because their market perception deteriorates. Take a scenario: Bank B is rumoured to hold a portfolio of incredibly weak mortgage assets that the rest of the market won’t touch. The share price drops and the credit spread on Bank B CDS’s widens. The board of directors swear that everything is hunky dory with the portfolio and in the absence of any market proxy or even requirement to mark the assets to market Bank B continues to hold the assets at 100% of face value. Meanwhile in its fixed income division, the widening of Bank B credit spreads means that they book a profit on some exotic borrowing dressed up as a derivative.

So how much of this shows up in the UK banks:

RBS - Page 207 of the2008 annual report shows own credit gains of £2.823bn ($4.15bn)

HSBC - Page 31 of the 2008 annual report shows $6.57bn of own credit gains, on $6.5bn of profit for the year.

Barclays - Page 4 of the 2008 annual report shows own credit gains of £1.663bn ($2.44bn)

Now remember this item from the Barclays 2008 accounts>

“In an exceptionally challenging market environment Barclays Capital profit before tax decreased 44%(£1,033m) to £1,302m(2007: £2,335m). Profit before tax included a gain on the acquisition of Lehman Brothers North American businesses of £2,262m.Absa Capital profit before tax grew13% to £175m (2007: £155m).”

So we can update our earlier comments Barclays Capital made £1,302 million of which £2,262 million came from a gain on buying Lehman (Barclays decided it was worth £2.2 billion more than they paid, but nobody else thought it was worth paying the extra), and £175 million from Absa, so the rest of Barclays Capital lost £1,135 million, but it seems we can take off £1,663 million because that was just gains from own credit CVA’s, so Barclays Capital actually lost £2,798 million.