Dealing with financial aftershocks

While there are increasing signs that the world is emerging from the deep 2008/2009 economic recession, there are also plenty of signs that the impact of the recession will be felt for a long time to come – among others, in the fundamentals of how the economy is structured and in the realm of the regulatory environment. For now, major banks at the recently held meeting of the World Economic Forum apparently have softened their stance on regulation, but it is becoming clear that new accounting standards to simplify financial asset reporting and make it more transparent are likely to be of the first new regimes of the post-recession world.

Besides the regulatory authorities in most major Western countries being in the process of visiting the reporting regimes for their financial sectors, the International Accounting Standards Board (IASB) has agreed to a complete revision of standards on accounting for financial instruments.

The aim is to replace the IAS 39, an international accounting standard, with a new standard – referred to as IFRS 9 – to deal only with financial assets. This will be done in three phases, with the final phase due to be in place by the end of this year. The first phase specifies how a financial institution should classify and measure financial assets, including certain hybrid contracts, which was at the centre of the near collapse of the financial industry.

The board was also working on when to, and when not to, re-recognise financial instruments from the statements on the position of an institution and on revising the consolidation of standards. The proposed changes would result in many more so-called off balance sheet structures being brought on balance sheet.

To cater for the extent to which the risk exposure of financial institutions has become intertwined globally, another requirement was to remove inconsistencies between the United States’ Generally Accepted Accounting Principles (GAAP) and international financial reporting standards.

However, Lord Adair Turner, chairperson of the United Kingdom's Financial Services Authority (FSA), recently warned that some bank regulators are planning to drive a coach and horses through the new loan loss standards proposed by the IASB, by interpreting the rules in a far more radical way than accountants envisage.

The IASB's proposals, published on 5 November last year, would replace the current incurred-loss model with one based on expected loss, satisfying some critics in the regulatory community but disappointing others who had hoped for the rules to embrace a dynamic provisioning approach similar to that used in Spain.

Turner claimed that these regulators would seek to squeeze the Spanish model into the confines of expected loss.

Signs of tension

"There is tension here. There are regulators around the world who are going to take the IASB's expected loss approach – whatever the IASB says – and require banks to do Spanish-style dynamic provisioning under that," Turner said, responding to an audience question following his keynote speech at an event organised by the Institute of Chartered Accountants in England and Wales (ICAEW) at its headquarters in London.

Friction between accountants and regulators arises from a fundamental difference in their objectives, which Turner highlighted in his speech – accountants want to tell investors how a bank is performing today, while regulators want banks to hold big reserves for tomorrow.

As such, many observers have been anticipating fierce debate over exactly what is meant by expected loss – but Turner's remarks suggest some regulators have decided simply to impose their own view.

For its part, the FSA recognises accountants will resist interpretations that de-link expected loss from transparent, point-in-time inputs, Turner said: "We expect, when we get down to the detail, accountants will not allow that much judgment in a single-line item – that's why we said we should look at putting two lines in there."

The FSA's proposed solution is to keep the existing incurred-loss provisions on one line and to supplement that with an additional figure incorporating more forward-looking information and management judgment – but Turner conceded that the idea has not found much support.

American efforts

The loan loss debate could intensify when the US standard setter, the Financial Accounting Standards Board (FASB), publishes its own proposals on loan loss accounting. These may arrive as early as March and, accounting sources say, are likely to endorse an expansion of fair value. Such a move would infuriate both the IASB and bank regulators.

Turner said US investors and the FASB "appear to be devoted to fair value accounting", and added that this affection "can appear strange in the face of what happened during the crisis."

He said that on the trading book side, much has been done already, pointing to the Basel Committee's overhaul of the regulatory capital framework – but he warned that more changes could be on the way.

"This year will see a fundamental review of the trading book regime, going right back to the question of why we have separate regimes – why does an asset on the trading book attract less capital than the same asset on the banking book? The result is likely to be higher capital requirements in periods of stress and illiquidity," he said.

In addition, Turner called for "new counter-cyclical macro-prudential tools" that regulators could use to rein in dangerous expansion in credit or irrational surges in asset prices.

As an example, he said it may be helpful for regulators to be able to impose additional capital requirements on specific lending businesses – such as commercial real estate – when the market is booming. But he conceded that such tools could be influenced easily by political motives if left in the hands of regulators alone.

Banks are drivers of volatility

"No other sector of the economy is remotely comparable to banking in its capacity to be a driver of economic volatility rather than a victim of it. Prudential regulators, central banks and economic policy-makers have a vital interest in the decisions of accounting standard setters in relation to bank accounting standards, which doesn't apply between regulators and accounting bodies in any other sector of the economy," Turner said.