Why you should steer clear of bank stocks

Until the Cyprus crisis broke, bank stocks were enjoying something of a bull run. Over the past five months, the UK sector had been rising nicely to end January some 30% higher than last October. Since then things have gone a bit pear-shaped, with the sector dropping around 10%.

And that's the way things should carry on going, according to a report by accountants KPMG highlighted by my colleague Bengt Saelensminde in The Right Side newsletter. The bottom line is that decent paper profits which certainly help share prices conceal all sorts of nasties, known in accounting speak as 'exceptional items'.

You'd think from the name that these 'items' would be pretty rare. But you'd be wrong. Financial results from banks seem to be peppered with them and on a fairly regular basis. So what are they? Well, in theory they offer a way for a bank to highlight large, one-off items that might muddy an investor's view of its underlying performance.

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It sounds sensible enough that a bank would direct you to look at the profit figure before such items if they are genuinely non-recurring. For example, say a small bank generates profits after exceptional items of £80m in 2011, £70m in 2012 and £60m in 2013. On the face of it, things at the bank are not looking so good.

However, then you find out that £20m of exceptional costs were incurred in 2012 and £40m in 2013. Take those out and the profit profile is now £80m in 2011, £90m in 2012 and £100m in 2013 that's better!

If these sorts of costs truly were one-off items, then you might say that these revised numbers better reflect the underlying operating profitability of the business and should be the figures that investors rely on. But these days that's often far from the case.

Delve into typical banking exceptional items and you will find that they consist of costs related to things like missold payment protection insurance (PPI) claims, regulatory fines, restructuring costs and one quite remarkable sleight of hand (see below). And the point is that none of these are one-offs any more.

Banks are being swamped by fines and misselling claims pretty much annually. Meanwhile, a deep recession has seen most of them cut staff, again on a rolling basis. So it makes no sense to exclude these costs as "highly unusual" much though the banks would love you to.

Perhaps the dodgiest item you'll find hidden here relates to how banks deal with downgrades on the debt they have issued. At the bottom of the market in the immediate aftermath of the credit crunch, the banks were hit with downgrades from the ratings agencies.

The way this is recorded is to say the least odd. Since a downgrade decreases the price of a bank's own debt, the issuers were allowed to book an exceptional gain to profits on the basis that if they had to repay the loan it would be cheaper to do so.

Recently, however, as some of the immediate credit risk attached to that same debt has faded, the banks have been forced to make a charge against profits as bonds prices have rallied and the same bonds theoretically get more expensive to repay.

In short, the irony is that the better the banks perform now, the bigger these charges to profit become. Unsurprisingly, these big downward adjustments are hidden away as 'one-off' exceptional items that investors are supposed to ignore.

The solution to all this nonsense is simple in my view: ban the use of exceptional items altogether. In the meantime, your best bet is to be very sceptical of the number 'profit before exceptional items' and to be particularly wary of banks who seem to be its biggest fans.

Looking at what's happened to bank share prices recently, it seems more and more investors are waking up to banking shenanigans. You could take advantage by shorting bank shares. Short selling itself (borrowing and selling shares you don't own) is limited to professional traders, but you can do something similar with a spread bet.