New rule undermines the banks

IN all the fuss about FRS 17, the accounting standard which demands that pension-fund surpluses and deficits be shown in the balance sheet of the sponsoring company, no one has focused on the particular problems the standard could cause for regulated businesses.

If a non-financial company is seen to have a deficit, the worst that is likely to happen in the short term is that its shares might fall. Not that this is to be taken lightly, of course, because if enough companies with deficits see their shares fall, it will reduce the value of pension portfolios across the board and bring about even bigger FRS 17 deficits for the following year - thereby provoking a further fall in share prices and setting the cycle off again.

But the effect on banks is much more direct and much worse. If a bank has an FRS 17 deficit, this constitutes a reduction in its capital base. As capital is the raw material of its lending, having less of it means the bank has to lend less. So an FRS 17 deficit will lead directly to a scaling-back in the bank's level of activity which, in turn, will mean lower profits, and perversely, a reduced ability to make good the deficit out of earnings in future.

That at least is the theory, but we will have to wait to see what happens in practice. The Financial Services Authority regulates banks and monitors their capital. It could set great store by the standard, in which case the impact has the potential to be severe - particularly on small banks.

Alternatively, it could choose to ignore the impact of FRS 17, but having the regulator dismiss the number as irrelevant could undermine the credibility of financial accounts in general. That is a dangerous thing, as we have just seen in America, because it has a hugely damaging effect on investor confidence. It is a tricky issue for the FSA but it is going to have to come down off the fence soon.

The implications go further. Suppose a bank has lent money in the normal way, with the usual asset based covenants, to a client only to find that an FRS 17 deficit means the client has breached the covenants. Does the bank ignore the fact and risk the regulator coming in, taking an opposite view and saying that the balance sheet is full of duff loans? Or does it take the hard-line view and call in the loan because of the breach of covenants, thereby screwing up its business and client relationship?

When the standard was drafted, the accountants thought it merely reflected business reality. It does. The problem is that because it affects the balance sheet, it goes to the heart of a business and changes business reality. This is not what accounting standards should do, nor were intended to do.

Gold beckons

SINCE I mentioned three weeks ago that something seemed to be stirring in the gold market, the price of the metal has soared and this week hit its best level in years.

There seem to be all sorts of reasons why. There is a potential shortage of the metal, in that demand will outstrip production and the central banks will not be selling much. In times of political uncertainty, people hoard it and this is particularly so when the uncertainty is in the Middle East and India. But most of all it does seem that President Bush's politically motivated protectionism of steel, textiles and now agriculture has undermined his administration's economic credentials in the eyes of overseas investors.

This has dented their confidence in the dollar and brought about a fall in the currency that may well have a lot further to go. Meanwhile, people looking for a safe haven are rediscovering the merits of the yellow metal. The ingredients are there for it to go higher still.