Fitch: Bank regulation is substituting accounting prudence

11 November 2013

Regulators are able to use capital adequacy requirements to employ a greater degree of prudence than currently allowed in financial reporting, Fitch Ratings says.

There are two examples from recent third quarter earnings announcements that highlight the divergence between regulatory and accounting assumptions.

First, the creation of an internal bad bank at RBS will not materially change the group's fully loaded Basel III common equity Tier 1 (CET1) ratio, despite an additional GBP4.0bn-GBP4.5bn of impairment charges to be taken in 4Q13 for reshaping this division. The ratio is expected to fall only by around 10bp. 

Regulatory capital calculation had already included a deduction for an expected loss (EL) shortfall of around £3.5-4.0 billion for this portfolio. The impairment charge therefore dents equity in the financial statements, but reduces the deduction from regulatory capital because the EL shortfall is now much lower. 

Basel's EL calculation is based on a forecast of losses on a bank's assets in the coming year, so the calculations are commonly larger (or more conservative) than impairment charges for financial reporting purposes, which are booked under the incurred loss approach. Investors' general preference for a more prudent approach has driven a proposed new accounting standard for credit loss, which plans to adopt an EL model. Fitch expects this will help shift accounting standards closer to regulation. But the new IFRS standard is still under consultation and will not be in place until 2017 at the earliest. Also, loan loss provisioning will remain highly subjective. 

The second example of regulatory reporting bridging the prudence gap from accounting standards is the requirement for UBS to set aside additional capital to cover operational, litigation and regulatory risks. FINMA, the Swiss supervisor, has imposed additional risk-weighting of CHF28 billion for operational risks from 4Q13. 

The temporary add-on at UBS comes over and above the bank's IFRS provisions for contingent liabilities, which require a strict assessment of probability with evidence to support calculations before provisions can be raised. Fitch believes it is largely a precautionary measure imposed by FINMA during a period when UBS, like many of its peers, is exposed to significant litigation and regulatory conduct risk, the outcomes of which are difficult to predict. Fitch is not aware of other banks being required to increase risk-weightings for operational risk as a result of ongoing regulatory and litigation cases, but there is a possibility that such practice may become more common. 

The differences in financial reporting and regulatory treatment of key bank risks can complicate stress-testing, as double counting is a possibility. Better disclosure can provide the best solution for analysts, so they can make their own adjustments to valuations, earnings and regulatory capital.

The regulatory focus on asset quality and contingent liabilities is being brought out in their various stress scenarios. For example, in the UK's 2013 capital exercise, the regulator adjusted banks' risk-weighted capital and leverage ratios for asset valuation, future costs of conduct redress and risk weights. Loan impairment is also one of the areas being examined under the ECB's Asset Quality Review for large euro area banks. 

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