As recently as the 1960s and 1970s banks in the US and UK and most other countries, unlike large businesses in other industries, did not have Chief Financial Officers (CFOs) or Finance Directors (CFOs). This was the age of Glass-Steagall, beginning in 1933, where commercial and investment banking activities had to be kept separated. As Sir Malcolm Wilcox, then joint general manager of Midland Bank of the UK commented on his retirement in the early-1980s: “It was an age when bankers thought they knew everything, including accounting and financial management!”

Arguably, the banking, insurance and financial industries have rarely distinguished themselves in the field of accounting. Secret reserves and profit smoothing have been rife for the most part – and international financial regulators have aided and abetted the process – wrongly believing that this made banks stronger and better equipped to withstand bad times, including runs on banks.

Secret reserves arise when a bank deliberately and routinely understates its net worth – taking the opportunity this provides to manipulate reported profits according to the wishes of management. This means that the results that the British banks and their predecessors reported to shareholders in the hundreds of years up until the 1980s were misleading and inaccurate. No wonder that the same banks did not bother to appoint finance directors until then.

The notion of having secret reserves only makes sense in circumstances where a company or a bank prepares consolidated accounts that include all the activities of a group – and where generally accepted accounting standards are followed. The example of the major German banks and companies that did not consolidate all their activities or follow normal accounting policies until relatively recently comes to mind. In reality the accounts of both the British and the German banks were equally meaningless.

In the same interview referred to above, Sir Malcolm Wilcox also complimented the Financial Times newspaper on having forced the British banks to abandon secret reserves and smoothing their reported results. “When we had secret reserves we knew what our reported profits for a year would be at the beginning of the year. Now we have to wait until after the year has ended”, he said.

The Financial Times campaign against banks’ secret reserves proved successful and British banks observed generally accepted accounting principles for most of the next 40 years. Many other countries followed and the general standard of bank financial management improved considerably for a few decades as banks appointed well-qualified CFOs. In the UK, Ireland, Canada, Australia, New Zealand and the former British colonies these were chartered accountants – while in the US they tended to be MBAs, who are also notable for their investor relations skills, with certified public accountants (CPAs) handling the accounting role.

The Global Financial Crisis (GFC) that broke out in 2007 turned everything on its head and brought back secret reserves. Central bankers, encouraged notably by the Federal Reserve in the US and the Bank for International Settlements in Basel, decided that banks should create provisions for potential future losses – which are supposed to be illegal under company law in many countries, including the UK.

The International Accounting Standards Board (IASB), the independent global standards-setting body on accounting matters, opposed the concept of provisions for future losses but eventually caved in to the banking regulators.

As a result banks everywhere will report results in bad times that are not as poor as those actually achieved; equally, they will report results in good times that are not as good as those actually achieved.

The HSBC Disclosures

An insight into secret reserves came to light in 1992 when HSBC was forced to disclose its true profits and shareholders’ funds when it changed domicile from Hong Kong to London.

The total amount of what it labelled “inner and hidden” reserves was revealed at the AGM to be HK$25.3 billion – which meant that the actual shareholders’ funds in the published accounts had been understated by 31 percent. Profits for 1991 of HK$8.5 billion turned out to be 51 percent higher than those disclosed in the 1991 accounts.

HSBC was the poster boy for secret reserves and was frequently held out as an example of why secret reserves were necessary in Hong Kong, a city well used to bank runs. Having said that, people were assured that published figures always showed the ‘trend’ of profits. The reality, as HSBC showed, was not the case. (The 1991 HSBC accounts carried an unqualified opinion from the auditor, now part of EY.)