Mervyn King of the Bank of England has warned that banks may be painting a misleadingly robust picture of their financial health due to banker’s widespread use of loan forbearance.

The use of “creative” accounting is disguising the true scale of loses of loans and the banks new Financial Policy Committee has called for an investigation into the practice by the Financial Services Authority.

Over recent years banks have frequently waived breaches of loan terms rather than foreclosing when corporate borrowers and individuals have difficulties. Of course, this can be positive for the economy because it keeps down the level of insolvencies and gives struggling borrowers time to repay the loan but it also means that profits and capital may be overstated in the banks’ accounts.

The situation carries parallels with the “zombie” companies of Japan in the 1990’s. Instead of foreclosing on over indebted companies, Japanese banks continue to lend to them, depriving healthy industries of capital and contributing to the economy’s prolonged stagnation.

This is particularly worrying in respect of commercial properties where there has been a 45% peak to trough reduction in property values.

The banks calculations suggest that about one third of the 243 billion of outstanding commercial property loans may be subject to forbearance, but Andy Haldean, the director of financial stability, said that estimates ranged as widely as 30% to 80%.

More than 40% of commercial property companies with revenues of more than 1 million pounds are generating profits that are insufficient to cover their interest payments, despite the very low levels of interest rates.

Sir Mervyn said “this is not to suggest that forbearance is wrong: it may well make sense for both parties to a loan. But if provisioning is inadequate, banks’ reported profits and levels of capital may provide a misleading picture of their financial health”.

An FSA investigation revealed that in the year to March 2010 the flow of residential mortgages into forbearance was four times higher than the number of repossessions or arrears.

In its latest report on the British economy, the International Monetary Fund said it was worried about the widespread use of forbearance, saying that the finances of Britain’s banks may be more brittle than at first sight.

“While it has undoubtedly alleviated some of the strains of the latest recession, leading to lower corporate liquidation rates than in the downturn of the early 1990’s, it also causes a number of “distortions” – a bank spokesman man said.

Given that banks are not consistently recording forbearance in their books; it is hard to get an accurate picture of the true state of their balance sheets. It is tying up bank funding that could otherwise be put into better investment propositions. It is a strategy that could go badly wrong if interest rates rise, making the loan even more unlikely to be paid.

This highlights, yet again, the difficulties in untangling the balance sheets of banks and assessing their strengths.

Tim Corfield, Managing Director of Griffin & King Ltd.

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