Saturday, March 13, 2010

Pumping up bank profits- Shattered Accounting

Accounting standards in Indian banking has been relaxed, at best of times. The regulator also steps in from time to time and helps out the banks.
Let us look at the PSU banks. Their asset quality, at most times, is as close to junk as possible. The SME sector to which they lend, informally accounts the bank loans as their 'income'!

I have seen virtually over a hundred types of accounting inventions used by banks. The latest one, though, seems worth a 'honorable' mention.

A couple of PSU banks applied for 'tax free' bonds, in a big way. Tax free bonds yield around 6 percent and the interest income is tax free. Surely a better proposition than lending to SME. However, should banks be investing in these kind of paper at all? Was having a debate on that with a friend. He said that the reason is something different.

Apparently, the bonds are 'marked to market'. Pray, what is wrong??
The story now gets interesting.

These bonds are 'grossed' up to arrive at a 'pre-tax' yield. For instance, a sixpercent tax free becomes around nine percent 'gross'. So, what this bank does is that it takes the future ten years to maturity on these bonds, discounts the gross yield (that is the notional three percent extra percentage points) and 'increases' teh fair value of these bonds! For instance, a 100 rupee tax free bond would be valued at around 106 or so!!
Now, when it is finally sold, the actual realisation would be only 100. The 6 bucks would have to be written off.
However, there is a ten year lag between the mark up and the write off. By then, the present chairman would have gone away, having delivered handsome profits now!
Of course, the RBI will do nothing. This is because someone has to 'bring it to their notice'. And of auditors, less said the better. you can bet, that they will sign on the dotted line. After all, the chairman sanctions loans, which I take to the bank as a broker. Why upset the apple cart??

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