Nicholas Jones: The way to control the banks is through their accounts

While politiicians have the power to stop gambling, they encourage it
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As he polishes his Budget Speech, now is an ironic time for Mr Darling to make its centrepiece a "pollution tax" on the investment banks' riskier activities. That's because his solution to the problems of bad banking comes hot on the revelation that it was dodgy accounting which helped destroy Lehman Brothers.

This awkward truth seems particularly to have shocked Opposition politicians. Yet we can expect the Chancellor to make no mention about reforming the accounting industry. It rather begs a question: don't politicians know this sort of thing goes on in the City ?

Until the Government tackles the banks' accounting practices, it will get nowhere near solving the problem of risk-taking. But an observer of the City would naturally ask how ministers would set about accountancy reform to stop fresh Lehman-style abuses.

Alas, once you study the problem, you reach a depressing conclusion. The institutional shareholders, the very people who should stop the kind of practices in which Lehman's engaged, end up encouraging them. Consequently, it's hard to see how reform of abuses might work.

A simple analogy will describe what Lehman's was able to do. Imagine you are in negative equity but need to borrow more money. Let's say you bought a £1m house with a mortgage but it's now worth £700,000. There is a simple way to conceal the £300,000 loss – just call the transaction a "Repo 105": there is then no obligation to reveal your difficulties.

Cormac Butler, author of Accounting for Financial Instruments, describes Repo 105 transactions as "a variant of off-balance sheet accounting that should have been abolished years ago". However, if you work in the City and are on a huge bonus, off-balance sheet accounting is a godsend. Many observers think that it is an integral part of City trading. Politicians need to grasp this before urging action, or they will look ineffectual. When something can make wealthy people even richer, they are not likely to give it up.

It's well-known that the bonus culture encourages gambling. It also leads traders to borrow massively, because the more you wager, the greater the chance of winning. And, of course, losing – but with off-balance sheet accounting the losses can be hidden.

Another simple example shows how this works. Mr Banker and Mr Shareholder play roulette in a casino. Shareholder offers Banker a deal. If the ball lands on the red Banker can keep 20 per cent of his winnings but if the ball lands on the black, Shareholder assumes the losses. Mr Banker can make himself rich by betting as much as possible – and if he can borrow money for gambling beyond what Mr Shareholder has provided, (a process known as leveraging), he stands to make a fortune, particularly if he borrows in Mr Shareholder's name.

As applied in the banking world, such a practice often leaves the shareholder in the dark. For the private investor, it can be ruinous. For his institutional counterpart it's rather different. A Repo 105-style transaction allows losses and borrowing to be concealed.

It's thus little wonder that investment bankers are addicted to borrowing heavily. Ministers have called on the institutional investors who exercise real control over companies to police their management better, to reduce risk. But while they have the power to stop the gambling, they end up encouraging it. There are complex fee structures and conflicts of interest in the world of institutional investment which encourage short-termism.

Politicians calling for accountancy – and wider City – reform must acknowledge a truth about today's capitalism and apply it to banking. They still seem to assume shareholders invest in a company and thus nurture it. They elect directors who then run the company as the shareholders want, and create wealth.

But this model is bust, because most equities are now controlled by institutions. They use this control for far more profitable things, like trading, mergers, disposals etc. These activities are what the City is about – not running companies successfully.

Flawed accounting is probably the last item on the institutions' agenda since any losses are passed on to pensioners and small investors. If off-balance sheet accounting were stopped, the losses traders made would have to be revealed more quickly, along with the borrowing levels.

Such traders would lose their jobs, bonuses would be drastically curtailed and a massive caution would descend on the City. Its very culture would change. If that's what ministers hungry for reform really want, they should have the courage to say so.

The writer is creative director of Quanta Films