04 June 2012

IASB Chairman Hans Hoogervorst: Primary purpose of financial reporting – transparency vs stability

At the third ECB Conference on Accounting, Financial Reporting and Corporate Governance for Central Banks in Frankfurt, Hans Hoogervorst addressed whether the primary purpose of financial reporting should be to provide transparency, or if it should also serve the goal of stability.

Transparency and stability are often juxtaposed as if they were conflicting goals. In Mr Hoogervorst´s view, it is clear that transparency is a necessary precondition of stability. Indeed, a lack of transparency significantly contributed to the credit crisis. Huge risks were allowed to build up both on and off balance sheets without being noticed. Without proper transparency about risks, stability is bound to collapse in the end.

In short, stability is not the same as transparency, but there can be no durable stability without transparency. So accounting standards/financial reporting can contribute to stability by enhancing transparency.

Stability should be a consequence of greater transparency, but stability cannot be a primary goal of accounting standard‑setters. The IASB cannot set capital requirements for the banking industry. This instrument belongs to the prudential regulators and central banks which do have stability as their main mission.

What accounting standard setters can also not do is to develop standards that make items appear to be stable when they are not. Accounting standards should not create volatility that is not already there economically. But, if volatility exists, accounting standards should certainly not mask it.

There are plenty of ways in which the accounting standard-setters are trying to make a contribution to greater transparency in the financial industry, often in close consultation with the prudential community and regulators, such as the Basel Committee and the Financial Stability Board.

First, the accounting standard‑setters have improved consolidation requirements to prevent undesirable off-balance‑sheet financing. In particular, US GAAP was tightened up in this respect. While the broad consolidation principles of IFRS held up reasonably well during the financial crisis, in the United States off-balance‑sheet financing through special purpose vehicles and repo transactions was more of a problem. With tighter consolidation requirements and better disclosures, the IASB and the FASB can reasonably hope that this problem will now be a matter of the past.

The use of fair value accounting has been the biggest bone of contention between accounting standard‑setters on the one hand and prudential and central banking authorities on the other hand. Opponents of fair value accounting state that too much reliance on market prices exacerbates the economic cycle in both upturns and downturns. These critics believe that fair value accounting strengthens pro‑cyclicality and thus leads to artificial volatility, which threatens stability.

This line of reasoning was greatly reinforced by the fact that the efficient market hypothesis was heavily discredited by the financial crisis. The ECB and the Basel Committee asked that the IASB limits the use of fair value to address this pro‑cyclicality.

Many independent studies have concluded that fair value accounting played at most a very minor part in the turmoil of the financial crisis. That conclusion was only to be expected, given that the bulk of traditional banking assets (e.g. loans) are still valued at amortised cost.

The IASB has decided to continue with a mixed measurement model in IFRS 9. In IFRS 9, financial instruments that have basic loan features and that are managed on a contractual yield basis are measured at amortised cost. For such instruments, amortised cost is deemed to provide more relevant information than short‑term market fluctuations.  The IASB is currently reconsidering limited parts of IFRS 9.

The IASB recently decided to re-establish a fair value through OCI category for debt instruments that are managed with the objective of both collecting the contractual cash flows and selling the assets. This can be the case for assets that are held for liquidity management.

The last area of transparency relates to impairment. A well-functioning impairment model is of paramount importance for an amortised cost measurement to be reliable and credible. After the outbreak of the crisis, the IASB's current impairment model, which was based on incurred losses, was criticised for being too little, too late. The fact that the market capitalisation of many banks is far below their book value is an indication that market participants do not believe that their current level of provisions reflect economic reality.

Both the IASB and the FASB are convinced that a more forward-looking impairment model is needed.

Mr Hoogervorst is convinced that the introduction of the expected loss model will be a major improvement. First, it should lead to provisions being made in a more timely and realistic fashion and a heightened, more forward-looking risk awareness in the financial industry. Secondly, a timely clean-up of the banking system should free up resources to viable sectors of the economy instead of exercising forbearance on essentially defunct companies.

Thirdly and perhaps most importantly, there is nothing more damaging to the credibility of the financial sector than serial underestimation of the true magnitude of problematic assets. Partial recognition of inevitable losses may buy time in the short run, but in the end leads to round after round of ‘definitive’ rescue programmes and a gradual erosion of confidence in the markets. It is obvious that for a rigorous and adequate application of the expected loss model, banks need to be properly capitalised. Whether the recent reforms of the Basel regime for capital requirements go far enough in this respect is open to debate.

In conclusion, Mr Hoogervorst said that the introduction of an expected loss model can lead to a much more timely recognition of losses than is currently the case. The incurred loss model provides too much leeway for procrastination and has to go. But an expected loss model in itself should not be expected to significantly dent the pro-cyclicality of the credit cycle.

Unless bankers and their supervisors become a lot better at containing credit booms and their risks, busts with massive losses will periodically take place. Even then, an expected loss model is preferable to an incurred loss model. But for an expected loss model to be applied rigorously, it is essential that banks are well capitalised. If such is not the case, even law-abiding banking supervisors might be tempted to buy time by condoning some stretching of accounting rules. Obviously, that is a temptation to which nobody should be exposed. 

Full speech

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