27 June 2013

BIS/Knot: Financial stability through transparent reporting

Mr Knot mentioned that the accounting domain, the prudential domain and financial stability cannot be seen separately. The main thread of the debate has always been “unexpected losses versus expected losses”.

How to translate the prudential notion of expected and unexpected losses to day-to-day accounting practises? Mr Klass presented two messages:

• Accounting standards should be designed to reflect expected losses, no more and no less than that. And own funds should be designed to absorb unexpected losses.
• Financial reporting and financial stability supplement one another. They are like a horse and carriage.

He believes a combination of transparent capital requirements and accounting concepts based on expected losses, would boost trust in financial institutions and thus improve financial stability.

How does this translate to financial reporting and capital requirements? In the debate, prudential regulators are often accused of building in unexpected losses in loan loss provisions. The Basel Committee distinguishes between expected and unexpected losses. It argues that capital requirements should be robust enough to cover unexpected losses. And the Basel Committee welcomes that the IASB is considering including the expected loss notion in their new financial instruments standard, IFRS 9.

For banks, Basel III specifies that the minimum levels be increased and expanded with so-called capital conservation and countercyclical buffers. Capital conservation buffers are to be built specifically in good times, through profit retention. And countercyclical buffers are meant to be created in times of rapid credit growth, when banks extend a lot of new loans. Such periods are followed by a prolonged financial downturn.

As far as the supervisory requirements are concerned, it is the explicit aim that the granaries be filled during the good years. Supervisors play a crucial role in ensuring that banks comply with this requirement. But there’s an important role for accounting standard setters here, too.

Investors believe the banks have not yet put these future losses in the books and are thus sceptical about their financial health. For when part of the capital will be used to absorb expected losses, they know that less will be available for unexpected losses.  Whether these investors are right is irrelevant. What is relevant is that this fear stems from knowing that banks apply the incurred loss-model. The impairment requirements in the current standard, IAS 39, are just not sufficiently forward-looking.

In Mr Knot´s view, it is therefore highly advisable that the impairment requirements in the new accounting standard are made forward-looking. High-quality accounting standards should form the foundation on which these capital buffers are based. Sound reporting will increase trust in the institution.

But IFRS 9 also contains other elements that are quite relevant to us. These are the classification and measurement sections. It’s generally accepted that a bank’s economic value is determined by its cash flows. Accounting standards should reflect this. That’s why he is in favour of introducing the business model criterion.

If the bank’s business is trading, then the Fair Value-method would give a good estimate of future cash flows. If the bank specialises in hold-to-collect management of financial instruments, then unrealised gains should not be part of its own funds.

The IASB is considering introducing a third category, the so-called Fair Value Through Other Comprehensive Income, or FVOCI. This new category resembles an old one, the Available-for-Sale category. The very category that caused a lot of uncertainty during the crisis. He would therefore advise the Board to see to it that this third category is made subject to robust conditions, to ensure that this regulation leaves no leeway for arbitraging.

He concluded that converting from incurred loss to expected loss would greatly improve things. Accounting principles should take into account expected losses as soon as they are perceptible. This means that the expected loss notion becomes part of the amortised cost principle.

This notion is quite similar to fair value notions that include losses in market indices. These also tend to bear a forward-looking element. Both approaches would give very clear estimates of possible credit risk losses. And, of course, this would serve financial stability.

In closing, he introduced three basic principles:

• Transparent reporting of expected and unexpected losses contributes to financial stability. We should make buffers in own funds for unexpected losses and book in the expected losses as part of the new amortised cost valuation method.
• Prudential regulators and accounting standard-setters such as the IASB share an interest. Prudential regulators promote sound risk management practices – and accounting standard setters promote sound financial reporting. Both are prerequisites for a sound banking system and, consequently, for financial stability. He therefore calls upon the IASB to continue its cooperation with the regulators, including the Basel Committee.
• The expected loss model must be included in the IFRS 9 standard for financial instruments – as soon as possible.

Full speech

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