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Just a quick note that Ozrisk will be hosting the next Cavalcade of Risk. If you can think of any blog posts on the area of risk management and believe they deserve a bigger platform, feel free to submit the post using this form.

Note, though, that submission does not guarantee publication.

The current edition is here.

Thanks to financialart for the point at the BCBS’s response to the partial draft of the replacement to IAS 39.

Frankly, though – I am disappointed by their (the BCBS’s) response – which I shall refer to as “the document” from this point on. Overall it is a long wish-list which is in places self-contradictory and makes a couple of evident misunderstandings on the role of IAS 39. For a start, the document makes it look like IAS 39 is just for banks, when it applies to all IFRS reporting entities – and so it has to be able to work for everyone, not just banks.

Perhaps using the old “Good, Bad and Ugly” criteria would be useful – but in reverse order.

The Ugly (the Contradictory or Confusing Parts)

To make one thing clear up front – IAS 39 is an accounting standard, not a prudential standard. Its role is to provide accounting information to external users. Accounting, by its very nature, is (and should be) concerned with facts and (where possible) should avoid as far as possible the use of models to provide accounting information. At times this is not possible (for example in attempting to determine how much of a loan portfolio meets an IBNR classification) but where models must be used they should be very restricted in scope and the accompanying disclosures should be clear. Prudential standards, however, need to be forward looking to a much greater extent as they are designed to answer very different questions.

Accountants are meant to answer questions like “How much was that position worth on balance date?” and “What was the net profit for the year?”. Prudential rules need to be able to answer questions like “What is the probability of this bank failing over the next 12 months?” and “How much liquidity is enough?”. These are very different questions – but the BCBS seems to be trying to have an accounting standard that does both.

The document is also asking (and I agree with it) for a simpler set of standards – they devote a whole section to this request – and then in subsequent sections they ask for what could only be provided through increased complexity. For example, a move from an incurred loss model to a more prudential style one would effectively mandate that every single publisher of financial information using IFRS (i.e. every company in Australia) would need a prudential loss model for their creditors. The new standard would also have to spell out how that was to be done and this would represent an enormous increase in complexity, particularly for smaller banks and non-banks. If this is not to apply to everyone then we would need at least two (differing) impairment models, increasing complexity even further.

The document is also calling for the new Standard to be introduced with a timetable consistent with “financial stability”. This is nonsense. A new standard takes years to write and consult about – this one up until 2012 – so trying to time its introduction is just silly. If it is a better standard it will improve reporting, and so will enhance stability. If it is not, it will hurt and so should not be introduced. Either way, trying to time the end of a multi-year process to enhance “financial stability” is just silly.

I would also add the last sentence of an otherwise Good first section into here – the main point of accounting standards is to provide (as far as possible) “truth and fairness”. Increasing “market confidence” should only come from being respected, not from attempts to tweak the standards to hide the truth.

The Bad

The “tweaks” referred to above are in para 10 of the document, where there is a call to “de-link” the valuation from “certain aspects of income and profit recognition”. The call here is not clear at all and could result (if incorporated in the Standard) a significant role for management judgement in the valuation of difficult to value items. This element will always have to be there, but the sorts of language incorporated here is just dangerous.

Probably the worst misunderstandings in the document are in the area of fair value – with the writer of this letter mixing up the two related (but not identical) concepts of fair and market value. IAS 39 is pretty clear that there are differing ways to measure fair value and only the first (market value in an orderly, liquid market) is really discussed here. The author clearly confuses the two – witness point 4(b) in the document, where the author says that “the new standard should…recognise that fair value is not effective when markets become dislocated or are illiquid”. Ahem – the current standard does that, as does the new draft.

Another Bad bit is directly above – an accounting standard should not “…reflect the need for earlier recognition of loan losses…” than the current standard does – that is a prudential standards’ role. Doing it here would just go back to the old system where management were (to an extent) allowed to put whatever they liked into the provision for doubtful debts. The current method, while at times complex, at least is less susceptible to manipulation.

The Good

To be fair, though, I should recognise the excellent parts of the document. The first section is a combination of motherhood and useful statements (except for the last sentence). The call for more meaningful disclosures is good, and one I have made before. IFRS 7 is both overly complex and too simplistic simultaneously – a good trick at the best of times. The call in the letter to have it revised is timely – the suggestion to make the disclosures in a more standardised format is a good one.

Section 2 and 3 are good – but are contradicted (as covered before) by (inter alia) paras 12 onwards. The rest is broadly good – but mostly just covers areas that are self-evident anyway.

Overall, if this were given to me by a new graduate attempting to write a wishlist for the new IAS 39 I would hand it back with a few complimentary notes on it applauding their efforts. Coming from a major regulator (never mind the peak banking body) I can only shake my head.

I have just started reading a book by Tim Carney entitled “The Big Ripoff” and he makes many of the points I have made time and again – the effects of regulation are generally not the ones you would expect.

The fans of regulation are generally taken to be opponents of “Big Business” and they call for more regulation as a counter to the (alleged) pernicious effects of having large companies. Most of these effects are easy to see – strong pricing power, reduced service and many other things that are bad for the consumer.

The argument that Carney puts forward, though, is one I have been making for some time – both on this blog and elsewhere. The argument is a simple one. The more regulation you have in a market the more that regulation will favour the big suppliers – i.e. the larger incumbents – over the smaller incumbents, any potential new players, and, crucially, the individual consumers. So the more that you regulate the worse the situation gets for everyone but “Big Businesses”.

The reasoning is simple to see if you think about it – compliance is expensive. I know this as a simple fact – and my fee base confirms it. It costs money to comply with regulation. The more complex it is the more expensive it gets. For example – complying with the (old) Basel I Accord was a simple exercise. While it took a fair amount of work to get compliance when it first came in in 1988 / 89 most banking systems could comply with it fairly quickly and, importantly, cheaply.

While Basel II is a much better (i.e. risk sensitive) set of standards there is (I think) no-one out there that would claim they are simpler than Basel I. The amount of money that even a small bank following the Standardised / Basic methods of compliance had to spend was a fair leap from the amount they had to spend to spend under Basel I, and the amounts you have to spend to comply with the Advanced methodology (and therefore to get a substantial capital advantage) was many, many times more.

There is simply no way that a small bank or a new player can afford this without the belief that they will become a big bank (and therefore Big Business) as a result.

Even to keep the people needed to continue and upgrade these systems is expensive and needs a high (and profitable) turnover. There is no other way.

All of this means one thing – that more regulation makes it relatively more expensive for small businesses to operate that for large businesses and it imposes high barriers for new entrants into a market. Regulation therefore tends to help big business, not hinder it.

 

BTW – I should add that a post at catallaxy reminded me to write this one.

I’m in KL on a job for a few days, which is why things have been fairly slow around here.

It’s always good to get out for a few days for a reminder that there are always differing ways to do the same thing. I can’t really say why I am here, so I will just give a few impressions. Sorry for the vaguely twitterish post, but it’s all I can do at the moment.

It is almost 30 years since I was last in Malaysia other than on transit through the airport, so the first thing that hit me here was the sheer number of freeways everywhere. They are not only normal freeways, but most of them are that most expensive way of building them – elevated. Once I got to breakfast I was reminded of one of the more annoying things.

A lot of the time we whinge about the press in Australia. Other than the AFR, the press is pretty ordinary, with the proprietor’s views being over-represented. It is annoying, but there are normally dissenting views around.

Picking up the paper in the morning to read over breakfast I was reminded of how bad a government controlled press can be. Both of the major papers gave exactly the same priorities to exactly the same stories – and all of those were to pillory the opposition (always referred to as the opposition, even in those states where they are in government), explain why any opposition attacks were wrong or to glorify the BN government. It took about 20 pages to get through to any international news. Incidentally, almost all criminal acts reported in the papers were attributed to “foreigners” (read as Indonesians). Really annoying.

That said, they are better than the paper I remember from Indonesia when I was living there before the fall of Suharto in that they mention the opposition, but they are not that much better.

To me, that sort of reporting does tend to increase country risk as it allows the government to get away with some sillier actions without any real threat of domestic criticism. It also increases the power of rumour as people tend to believe the rumour rather than the papers.

That said – there is a lot to like here. There is substantially more wealth here than 30 years ago – the widespread poverty has now been reduced (but not eliminated) and I can go for a walk much more confidently than I remember doing a long time ago. That or the absence of my parents who may have been a little over protective.

The other thing to note is the expansion of the Shari’a compliant financial system. The advertising is everywhere and there is clearly some serious business being done in it. It may not meet the more narrow interpretation being used in the Gulf of what is Sharia compliant, but they are plainly turning a lot over.

Back to more normal service (including an update on the Australian Pillar 3 reports) next week.

Following up on the previous post on the GFC, there is a very interesting article in the Wall Street Journal that makes a very good point on the causes of, and solutions for, the current recession. In a simple table, (about half way down) it makes a very strong point – the depth of each country’s recession has been very strongly linked with the amount of government debt. Those countries that avoided recession had little or no government debt in 2007. Those that had big government debt have had a long recession.

If I remember my university economics properly, a good Keynesian economist would at this point rush in and point out that Keynes himself believed that debt should be net zero over the cycle and, as 2007 was pretty much the peak of the boom debt at that point should have been zero or less than. They would be right.

It does, however, show the importance of fiscal responsibility if you want to avoid prolonged downturns.

A second point that the author makes is that having the US Fed seems to have resulted in more severe and long term downturns than happened before the existence of the Fed. Again, this clear point must be equivocated by pointing out that the economy has changed since 1913 – but it is clear evidence that should be taken into consideraion when we are looking at policy responses to the recent (and now possibly finished) recession.

Hat tip – Cattalaxy.

Clearly there was a strong financial aspect to this, but an interesting post by two senior OECD economists over at vox raises questions as to the direction of causation – they point to new figures coming out on US and international labour market productivity as a possible cause, which later fed into debt problems. They are saying that the market missed this; largely because the data for productivity is slow to come out.

Interesting thought – else where I read that it may have been the 2008 oil price spike that essentially was the trigger on an already over the top lending problem. If you look at their figures (particularly for construction productivity) they have a good point.

Hat tip – BankWatch.

I have heard through the grapevine (thanks Ian at The Sheet) that Bendigo has fired the starting gun to the next big consultant’s feeding frenzy – they are talking about going for Basel II advanced accreditation.

I will be going through their numbers over the next day or so to see what this would do for them and will get back to you.

In the mean time, if you are with a major consultancy and have Basel II exposure you may want to dust of those proposal documents you did for the bigger banks, update them with the latest blurb and achievements and get them over to David Hughes (CFO) at Bendigo.

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