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As discussed below, quarterly disclosure of assets, credit quality and capital is supposed to be one of the “pillars” of the modern regulatory model governing Australia’s banking industry. Yet the mandated disclosure of this data is uneven, sometimes unavailable and, by and large, poorly read.

It was not meant to be this way. Theoretically, depositors and other investors in all banks were meant to take this information into account before making investment decisions. The fact that this is not happening means one of three things – it should be dropped as it is useless, it should be fixed or it just needs more time as people catch on.

The third possibility can be ignored, as the sheer difficulty of getting the data means that it is not probable that it will be done on a regular basis.

If we look at the second, then improvements clearly need to be made. Firstly, the target market for these disclosures needs to be determined – something that probably was not done before APS 330 was issued. In short – who is going to use this data? If it is the retail depositors, the mums & dads, then the data on the reports needs to be turned into something they can read and understand.

Some of the issuers of these reports are already doing this. Seventeen of the 121 issued reports feature explanatory information that may be accessible to the (relatively) unsophisticated user. Of the Big Four this includes CBA, the NAB and Westpac, with the standout being the Commonwealth. Their risk report seems to attempt to explain the whole 333 page Accord in each disclosure statement, the most recent of which was 87 pages long and includes a mass of detail.

Most of the disclosures, though, would have been meaningless to most mums & dads. To do as the Commonwealth does would also be a virtual impossibility for the small credit unions. Even to match, say, Westpac would be difficult.

Most of the disclosures simply take the bare compliance route – APS 330 mandates the tables to be included, so the data is in tabular format will either little or nothing by way of additional information. This is pretty difficult to read at the best of times.

Worse, and as is true of most disclosures, they really only are very useful when you can compare them to a competitor or to the institution itself, something that even the most sophisticated mum or dad would find difficult and time consuming.

If the target for the data is the wholesale market and credit risk analysts, the way that it is presented is also a problem. Given most institutions do not preserve a history on their websites, to get a meaningful data history means that an analyst would need to visit the websites of most of the 119 institutions that have one at least once every three months to get a full picture. For the four that don’t have a website an email or phone request would be needed.

The data would then need to be extracted from every report and then manually input into an analysis package.

This is clearly a lot of effort and, given it has not yet happened other than for this study, seemingly not a popular idea.

A possible technical solution to this would be for every ADI with a website to publish the data in a consistent way – possibly using XML or a similar method – to format the data for easy import into an analysis package.

Of course, this would mean than the 17 that are providing more and better information would have to be “dumbed down” to re-join the pack. Either that or they continue to produce the APS 330 formatted for general consumption as well as this other method.

A third possibility is that APRA itself publishes the report every quarter using data from its existing returns from each of the reporting institutions. This would have the benefit of a standard format and ease of finding. However, if APRA were to publish these reports then it would be difficult to avoid the impression that APRA has in some way endorsed the contents.

Perhaps they should be cancelled then – but this may be a breach of the Accord itself. There are two reasons why it may not be. The Accords were always meant to apply to “internationally active” banks, not to institutions with less than $1m in total capital. For the non-internationally active banks compliance with the Accord was a policy decision by APRA, not a requirement of the Accord.

Additionally, the Pillar 3 on which APS 330 is based speaks clearly about the concept of materiality – how it is the users that matter to this concept. The fact that there are so few, if any, users of these reports from the smaller financial institutions may well mean that the information is not actually material.

It’s clear that the APS 330 process, at least as it applies to the smaller institutions, needs to be re-thought. If we want to keep this form of market disclosure then it needs to be made useful to at least one group of investors or analysts. If the statements are not being used, then, perhaps, they should be dropped.

This is not coming out of retirement. I wrote this piece for Banking Day (an excellent way to keep abreast of banking in Australia) and I thought it may also be of more widespread interest. There will be one more piece tomorrow before I go quiet again.

Quarterly disclosure of assets, credit quality and capital is supposed to be one of the “pillars” of the modern regulatory model governing Australia’s banking industry. Yet the mandated disclosure of this data is uneven, sometimes unavailable and, by and large, poorly read.

Basel II Pillar 3 is the part of the international bank capital Accords that was intended to improve the discipline that the market imposes on banking institutions. It was meant to do this through increasing the amount and nature of disclosures that the banks (and other deposit takers) make on a routine basis, using the idea that more disclosure means there is more data and therefore better pricing.

There are, of course, two problems here. If the markets themselves are not pricing risk correctly (for whatever reason) then all the disclosures possible are not going to do the trick. The other problem is around whether anyone actually reads the disclosures.

The recent experience in Europe gives real pause on the first point. The Basel Accords themselves may be at least partially at fault here. The Accords effectively tell the banks that lending to their own government is so safe that they do not have to hold any capital at all against it. Most countries’ regulators also mandate that the bonds they receive for this lending are also always able to be sold instantly, and so count as being as liquid as cash.

Both of these now look, at best, overly optimistic.

What about the second, though? Does anyone actually read the disclosures and use them? If we turn to smaller Australian banks, building societies and credit unions, the answer seems to be a strong “No”.

Over the last few months these disclosures by all of the 123 banks (including the big four), building societies and credit unions operating in Australia have been collected as part of a research project. According to APS 330 all of them should have been reporting these every quarter since September 2008, making (so far) 12 reports in total.

There are also two differing types of disclosures – for listed banks or building societies extra disclosures must be made semi-annually and for unlisted institutions the extra disclosures are made annually.

There are still several faults in the process, with a couple not reporting at all and others not reporting fully or properly.

Both of the institutions not reporting were very small, but several of the other problems were more wide-spread. Of the 121 actually publishing, eight seemed to want to hide the results, making them virtually impossible to find on their websites, while six institutions had missed important data off the disclosures, including core numbers such as assets and impairments.

Three of the disclosures had clearly not been formatted for any sort of use.

Other problems were more widespread. For the June quarter end 14% (17 in total) of the disclosures were not out on time (40 business days after the relevant quarter end) – and this included three of the 12 banks.

The widespread issue, though, is that nearly 70% of the institutions are only making their most recent disclosure statement available – meaning that there is often no history or context, but, more importantly, for most of these the annual or semi-annual long disclosure is not on their website for at least half the year.

The other major problem is the sheer difficulty in harvesting the statements. The way that APS 330 mandates the disclosures is that they shall be put up on an institution’s website in a clear location. Formatting is meant to broadly follow the formatting in APS 330 – consisting of a variety of tables.

This was set up with the idea that an individual depositor could go to their institution’s website or offices and get a copy and then read it and understand their institution, and their risks, better. The problem here is that the basic format, and target audience, has not been thought through. There are not many depositors in the smaller institutions that would know the meaning of “Risk Weighted Assets”, “Tier One Capital” and the difference between 90 days past due or specifically impaired. Judging by many of the disclosures, not many of the preparers do either.

For your normal depositors, then, the disclosures are nearly useless.

For professionals, the situation is not much better.

Four ADIs do not have websites, making getting the data from them a process of calling or emailing them to ask for the data. For the others, it’s a matter of trying to find their website either by guesswork or using a search engine. If you are trying to get them all together and put them into a database it is a very time-consuming job.

The only people who may actually be able to use them, the wholesale providers of funds to the smaller institutions, would be able to get much better and timelier data direct from management.

There seems to be at least a few people reading, and using, the disclosure statements of the Big Four and Macquarie. This includes Banking Day readers, as the APS 330s for the majors are regularly reported there. However, it has not been noticed, least of all by APRA, that some institutions are not reporting at all, others are missing important data, several are late and most are not disclosing all of the data on a consistent basis.

It’s clear that the APS 330 process, at least as it applies to the smaller institutions, needs to be re-thought. If we want to keep this form of market disclosure, then it needs to be made useful to at least one group of investors – or analysts. If they are not being used, then perhaps they should be dropped.

Following the publication of a document on Islamic Finance (IF) by Austrade this week, perhaps we may get something serious in the way of development of this area in Australia.

Interestingly, the Trade Minister, in releasing the document, announced the release of a new product by Westpac – I wonder when Westpac will get around to announcing it. I would not find anything on their website. My guess is that this is just a toe in the water, because if they expected it to be a significant part of their business, they would have to make an ASX release about it. In that, I think they are right. A single specialised product is not going to be big in the context of and institution that size. That said, getting some credibility and experience will be a good thing.

For those interested in the area, a full read of the Austrade publication would be a useful thing. It provides a decent discussion of the IF market (although some of the data seems a little out of date as market growth has been hit by the Dubai problems). The issues identified in it are similar to the ones I identified a while back – the tax and regulatory structures in Australia need to be changed to remove the artificial impediments, find or develop appropriately qualifies Islamic scholars and we need to increase the knowledge base of banking professionals in Australia.

None of this is impossible – the regulatory stuff can be done quickly by essentially copying (at the State level) what Victoria has done and, at the Federal level, copying what the UK has done in regulation terms. Improvements on these could be made, but this would be a good first step.

Good to see at least something happening, though. It is a fascinating area of banking. In the mean time, read the Austrade document. It is pretty good.

I have been asked several times for a summary of what I think about the changes to the US banking system mooted by the Obama administration. Apart from not actually addressing the root cause of the collapse I believe the suggested changes will just make the whole thing more likely to recur next time the economy downturns.

The root cause, by the way, was over-lending by small commercial banks for mortgage purposes, aided and abetted by Fannie Mae, Freddie Mac, US regulations and bigger US banks that did not look too closely at some of their risk models in pursuit of short-term profits.

The best summary I have heard, though, and one that is close enough to my own views, is this one from the BBC, which I heard driving home yesterday. Give it a listen and then think about it.

It looks like the IASB is really interested in our opinion on the own credit risk issue. If you want to give them your opinion (and mine is pretty clear) then you need to become a registered user of the IASB website (come on – you know you are really interested and you do not have to admit it to anyone) and then email them at “owncreditsurvey@iasb.org”.

It would be worth doing if it gets them to a sensible position. Of course, many banks and other enterprises may find it “sensible” to allow the inclusion of own credit risk in the value of a liability – it would serve to reduce the disclosed value of the liabilities of the company, perhaps taking a failing enterprise to a position where they are then able to show a positive net worth. It would also improve the capital position of banks.

That would be a truly perverse outcome.

Following a suggestion I have been reading a book by Naomi Lamoreaux on the development of banking in New England1. It is called Insider Lending: Banks, Personal Connections, and Economic Development in Industrial New England.

She makes a number of excellent points in the book, and, to me, anyone with an interest in the development of modern banking should give it a look. Quite a few of the points she makes relate to the way that the improving understanding of credit risk, and the development of modern risk management, was, to a large extent, responsible for the development of modern, large banks.

I would argue, consistent with my earlier post on regulation, that it was not solely this, as an increase in regulation did play a major part, but I think it was more of a virtuous (or perhaps vicious) circle – with an increase in the size of banks, and an increasing ability to lend to whoever happened to turn up to the bank driving further regulation – which then effectively forced the smaller banks to grow or perish – creating more regulation.

The central point of the book is simple – early banking in the US (and, she presumes, elsewhere) was severely hampered by an inability to assess credit risk, so what happened was when a bank was founded it generally had several directors, men (and they were all men) of substance who effectively both lent their names to the bank and risked a large part of their fortunes in the venture.

In return, what they got was access to the banks funds, with a typical bank lending between 20 and 50% of its funds either to the directors or family members of the directors – the “insiders” of the title. They were, to an extent, protected from unlimited liability by the bank’s charter, but  this protection was often more illusory than real as to default would normally not only spell the end of the bank, but also the reputation of the individual directors.

The result was that the directors typically had an overwhelming say in the allocation of the bank’s lending, and they often lent to themselves or to others they knew well.

While today this may be looked on askance (and as possible criminal activity) then it was considered normal business for the reasons set out above. The difficulty of assessing credit risk meant that only lending to people you knew well (and, presumably trusted) was reasonably safe and, as you effectively had your own money on the line, you wanted to be really safe.

This had several effects – most people were effectively locked out of the banking system until they reached a point where they were rich enough to either own their own bank or to know someone who did. The second was that banks tended to be small – really small – with around 6 directors each and few employees. They also tended to have really high capital and liquidity ratios and charge really big margins. This then locked still more people out of the borrowing market.

The development of modern risk management practice, in all fields but particularly credit risk management, put paid to this model. While a few micro banks lingered into the modern era (and a few unit banks survive in the US) the bulk either went out of business or were bought out in the period up to the first world war.

The simple fact is that bigger banks, once you can overcome the difficulty of finding the good risks to lend to, are much, much more efficient2. If you can lend to more people, and people you do not personally know, you do not need your (comparatively expensive) directors to take every decision. You can directly obtain diversification benefits, cutting down losses per dollar lent. You can also, as a consequence, reduce your liquidity and capital ratios so you can drive more lending off the same amount of deposits (not, of course, that you can lend more than you have in deposits) and you can generally make more money.

For those campaigners for “social equity” it also makes a clear point – without modern risk management the poor are effectively locked out of the banking system entirely – so if they want (or need) to borrow funds they need to go to the loan sharks to get one. Personally, I would prefer to pay 6 to 10 percent to a bank than 20 to 50 percent to a loan shark. The bank also tend to not threaten to break my legs for non-payment. Banks can be funny that way.

The directors also become much more removed from the day-to-day operations,becoming more like the modern directors of a bank, able to reduce the risk to their own personal assets that may result from a bank collapse.

I would encourage readers to have a look for this book and give it a read, as it fills in a hole often left in the discussions on the development of modern banking.

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1. For those not familiar with the term, or who may be thinking of another New England as there are several, she means the US states to the north east of New York.

2. They can also, as I pointed out earlier, deal with the regulation better, and they can lobby government more effectively – i.e. be more efficient rent seekers.

The “final” released standard on classification and measurement as released today is – not final. This is for the simple reason that financial liabilities have been specifically scoped out. The reason for this is simple – the IASB cannot figure out what do do about “own credit risk” on liability instruments. If you want a full(er) discussion on this, please have a look at my last post on this topic, here. Suffice to say they seem to have recognised that this is a problem they were not going to be able to solve in the time they had given themselves, so they dropped it.

I am not sure how they can claim to have completed the first phase when they have dropped part of it, but, given the number of projects I have been involved in that have had to drop deliverables to meet a self-imposed deadline I cannot say I am surprised.

Normally at this point I would link to the finished standard and then talk about it. This, however, I cannot do as the IASB, in line with normal practice, wants you to pay to get to the standard. So instead what I will do is copy the summary of significant decision and then talk about each one in order. Once I have a hard copy of the standard I will give a more rounded response. I am too cheap to pay for my own copy when I can get one in a day or so for nothing. Read the rest of this entry »

As I believe we are allowed to call it now, the IASB will be hosting another webcast tonight (Australian time). I will be attending to keep up, as prompted by bruce in comments. If you are interested in the standard, and can stand listening to discussions on accounting standards by highly technical accountants late at night, I would suggest attendance.

I will be holding back on a full summary of this part of the new standard until after that webcast as, to be frank, some of the parts of the draft standard look very odd, and I want to make sure I understand them properly before I rush to judgement. At first glance, though, it looks like being even more technical than the existing, with an enormous amount more disclosure – some of which is likely to be counterproductive. The stress-testing disclosures could fall into this category, for example.

Many other things about it appear, ummm, very “interesting”. One thing in particular is the likely mandatory date – some time in 2013, with early adoption permitted. I cannot see many choosing early adoption if it is as I understand it to be – something actually acknowledged in the BCs.

If this goes ahead as it is I think it will be a(nother) feeding frenzy for the accounting firms. I might try and get back in.

Oh – and if you want to get a copy for yourself, it is here. Unless you particularly like reading standards, I suggest downloading the BCs as they are a touch more readable and cover their actual reasons for the decisions.

While this may be a little tangential to the normal run of posts here, to me managing regulatory risk is one of the things that any good risk manager has to do. Understanding the abilities and restrictions that the law has is an important part of that.

Over the last few months I have been putting the occasional post up here on what I feel is wrong with a lot of the regulatory framework. Skepticlawyer, being the very good lawyer she is, has done it better.

Legislation has two limits. One is practical (call it a ‘means-end’ limit). The other is principled (call it a ‘normative’ limit). Most philosophers spend all their time arguing over the latter: John Stuart Mill’s ‘harm principle‘ represents an attempt to get at what a principled limit on the powers of legislation may look like. This is philosophically interesting and forms a major part of my DPhil thesis here at Oxford. In the case of conservatives and social democrats, however, both groups engage in major legal wish-fulfillment: they think they can ignore ‘means-end’ limits. That is, they seem to think that passing a law will make it so. If wishes were horses, people, beggars would ride. They think they will, for example, be able to make abortion illegal (or greatly restrict access to it) with no social or economic comeback, or impose salary caps on business executives without hemorrhaging talent overseas or to other industries.

This is in the context of a piece on the Left in Australia – but the second half of the piece goes on to more general issues and it is this section of the post I would encourage you to read. It starts at the third paragraph after the blockquote in her piece.

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.

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