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A fairly late night for me – just finished this webcast (sorry, slides only ATM – they are releasing the webcast later). While the IASB were pitching this as a bit of a status update, they could not help but give some interesting pointers on where they are going and, as a result, what issues they feel fairly strongly about.

The main issues identified in the recent ED were:

  1. There seems to be a fair amount more clarity needed about the instruments that were to be allowed to be treated as amortised cost – the wording about “basic loan features” was considered a bit woolly.
    I would agree – but to me this should be able to be handled in some application guidance not in the main standard.
  2. There remain a number of questions around the own credit rating issue – if you fair value your own traded bonds you are implicitly including your own credit rating. This issue seems to be rather thorny. It may not go any further in any case as the IASB seem to be backing away from this, calling the method “not decision useful”.
    I would disagree – the issue is not difficult. An entity should not be able to recognise any possibility that it will not be able to meet its obligations as and when they fall due in any way, shape or form. This is a violation of the going concern principle.

Other issues covered were:

  1. Progress on the impairment model seems to be progressing – the use of an expected loss model seems to be one of the barrows the IASB are pushing, with the difficulties seen to be more around cost and practicality than general principles.
    They are proceeding to establish an experts advisory group to advise them on operational issues, application guidance needed and to facilitate field testing.
    I may have misunderstood here, but I do have a problem with this and on several levels. For anyone other than a very large corporate or a sizable bank this is not cheap to do. In Australia at least, this standard applies to all entities, so this is likely to be a significant cost.
    The other main problem I have is one of the whole principle. An EL model is inherently forward looking – yet a “Statement of Financial Position” is a point in time concept and an income statement is (by definition) backward looking. To me, the current impairment method is one of the strengths of IAS 39. Making it easier would be good. Violating the whole principle of financial statements is not. This seems to be one of the areas that the BIS would like to see in – but I have given my opinion on that before. I will be keeping a close watch here.
  2. Our old favourite of hedge accounting got a good look in as well, with an ED likely to come out in December. The changes here may well be extensive, with the IASB looking to simplify cash flow hedge accounting and making the fair value method more like the cash flow hedging. This could be achieved by changing it to have the hedged item left at amortised cost and changes in FV of the hedging instrument going through OCI.
    One word here – “yay”. If you want some more words – I have dealt with many clients that just gave up on this whole area – sometimes on my advice – as it was just too difficult. Changes here (the FAS 133 shortcut method, please and at first impressions I like the possible new FV method)  would be very good.

The other areas that were discussed were the likely effects on the upcoming insurance standard(s), particularly WRT to 2 above;  the possible removal of the cost exemption for instruments that are difficult or impractical to value and some consideration of what to do with these in interim accounts.

The IASB will be moving to weekly board meetings to try to get all this done in the timescales they have set themselves. Personally, I think this may be a sign that they are preparing to slip the deadlines.

The questions period was short – and the IASB wanted only process questions – but they could not really help themselves on a couple. The best question though, was on the convergence between IAS 39 and FAS 133, in that they both have very different timelines for releases but both are saying they want to converge. All I can say is “get on with it guys”. One standard (as long as it is simple and makes sense) is much, much better than two (or more).

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 been away from the purely banking risk area for a little while, so I had dropped my regular visits to the BIS website. Having headed over there for some stats recently I noticed how much they had beefed up their coverage.

A few interesting things have also appeared.

Deposit Insurance

The CP on deposit insurance that they issued in March has been updated into a full set of recommendations – the paper is here. Regular readers would know my opinion on deposit insurance, but in general the principles in this paper are sound. A worthwhile note is on page one:

The introduction or the reform of a deposit insurance system can be more successful when a country’s banking system is healthy and its institutional environment is sound. In order to be credible, and to avoid distortions that may result in moral hazard, a deposit insurance system needs to be part of a well-constructed financial system safety net, properly designed and well implemented. A financial safety net usually includes prudential regulation and supervision, a lender of last resort and deposit insurance. The distribution of powers and responsibilities between the financial safety-net participants is a matter of public policy choice and individual country circumstances.

Advice to our PM and Treasurer – do not do this in a hurry and in a poorly thought out manner. Nuff said.

Basel II Changes

Pillar I

The latest tweaks to the main Basel framework seem to be trying to do a little stable-door shutting on securitisation – with a fair bit of language added around understanding the risks and a few risk weights being increased.

Pillar II

The language of the amendments to Pillar II is also interesting – this places a large amount of emphasis on improved risk management at the banks, including reporting structures, concentration management and, in particular, the off-balance sheet stuff.

One recommendation in particular is interesting – the separation of the CRO’s office out of the business lines to report directly to the CEO and Board (pillar II amendments – 19).

Securitisation

This one is also good (pillar II, para 40):

A bank should conduct analyses of the underlying risks when investing in the structured products and must not solely rely on the external credit ratings assigned to securitisation exposures by the CRAs [credit ratings agencies]. A bank should be aware that external ratings are a useful starting point for credit analysis, but are no substitute for full and proper understanding of the underlying risk, especially where ratings for certain asset classes have a short history or have been shown to be volatile. Moreover, a bank also should conduct credit analysis of the securitisation exposure at acquisition and on an ongoing basis. It should also have in place the necessary quantitative tools, valuation models and stress tests of sufficient sophistication to reliably assess all relevant risks.

I would agree – but it should not take a regulator to tell a bank this. I wonder who is going to pay for all the extra analysts – or will banks just walk away from this market?
The whole document is worth a close read and I should get around to it soon. From my scan, though, I cannot see it having a significant impact in Australia. APRA was already doing most of this – but the changes to securitisation may cause some heartache amongst those institutions that rely on them, such as many credit unions and other smaller ADIs. I would be looking to the specialist mortgage providers and the bigger banks to benefit from these.

Liquidity

As expected, as well, the BCBS has boosted its look at liquidity – with almost as many mentions in the 41 pages of this as in the 400 of the Accord itself. Given much of the problems (like those at Northern Rock) at least started as liquidity issues this is not surprising. The language looks mostly drawn from the relevant Sound Practices document, but this incorporates it into the Accord itself. Again – not much to see here, as much of this is already in the relevant Australian liquidity regulation, and APRA is well across this.

Stress Testing

Brand new is a whole two pages on stress testing. As I highlighted nearly three years ago in one of the perennial favourite blog posts here – the original accord had little to say on the subject beyond telling you that it had to be done. The two pages here go some of the way to addressing that gap, but not nearly all the way. They are obviously leaving the wording fairly general here and leaving it up to national regulators still.

Pillar III

Much of this is focussed (as can be expected) on improving disclosure around the areas that have caused problems recently. Almost all of the changes to Pillar III are about increasing disclosure of securitisation exposures – with some consequential changes to the CRM stuff. None of this should cause any banks to sweat too much – these sorts of numbers have been demanded of the banks by the regulators for a while. It is just publishing the disclosures rather than sending them to the regulators.

Wrap Up

All of these comments, though, are fairly preliminary. I will need to go through this in a bit more detail and give it some thought. If I have missed anything, feel free to point it out in comments.

The new paper from the BIS on stress testing looks to be an important one. I have not had a chance to go over it in detail yet, but if you are in this area it is one you should read urgently. I would also add that much of this is likely to be incorporated in the next version of the Accord.

I will put together some comments on it over the next week as time allows.

For those interested in how regulatory prudential policy interacts with monetary policy around the world, you could do worse than go to a new paper produced by the Monetary and Economic Department of the BIS.

Introductory paragraphs:

It has long been recognised that that there is a strong complementarity between monetary and prudential policies. A sound financial system is a prerequisite for an effective monetary policy; just as a sound monetary environment is a prerequisite for an effective prudential policy. A weak financial system undermines the efficacy of monetary policy measures and can overburden the monetary authorities; a disorderly monetary environment can easily trigger financial instability and render void the efforts of prudential authorities. Economic history attests to this, as illustrated by the anatomy and consequences of the financial crises that have affected the industrialised and developing world, going back to previous centuries.
So much is agreed. What is more contentious is the view that some fundamental changes in the economic environment over the last quarter of a century may actually have tightened the interdependence between monetary and prudential policies, potentially calling for significant refinements in policy frameworks. In some research at the BIS in recent years we have been exploring this possibility in some detail.

I, personally would disagree with what is “agreed” above – to me, the contrast between “weak” and “sound” is a false one – a “sound” prudential policy can also be a “weak” one, such as using a free banking paradigm and allowing competitive non-state regulators. The “agreement” here is more likely to be amongst regulators and others in the regulatory industry.

That said, within the confines of the current system this is a very useful paper, even if it needs a little bit more proof-reading*. The authors’ access to data and people looks very good and the conclusions they have drawn out of the data and their references look useful.

The real “meat” here, though, is in the tables starting on page 20 – the analysis of the response of regulatory authorities to various financial events over the last 10 to 15 years. The last column in the table could be fuel for weeks of blog posts and discussion. The annex is also useful, being a “first pass” at assessing the impact of the measures taken. Again, for those interested in the area, this stuff is highly contentious, but this analytical framework is a useful one – comparing those countries with took both prudential and monetary approaches to tackling what was viewed as an imbalance to those which only took a prudential measures and looking at the results.

I am not strong enough in statistics to fully evaluate the results, but the methodology looks sound. If you are interested give it a look – and if your stats knowledge is better than mine feel free to give some feedback.

*Last time I checked it was the United States that had an S&L crisis, not the “Untied States”.

Just a quick note to welcome the (sort of) full implementation of Basel II in Australia – and its full implementation in most other jurisdictions (apart from, of course, the USA).

I say sort of in Australia as a few banks are staying on Basel I for some things, not others. The usual sort of “phased implementation” (AKA foul-up) you often get with major changes like this. Anyway, welcome Basel II.

The sideline on liquidity risk is to note that the one area that has caused the recent problems has been liquidity, not a lack of capital or other problems. Liquidity is the one area that is not really covered by international standards, with all differing regulators following different mechanisms (as noted below). The next project of the BCBS really should be to establish some standards in this area, and it looks like (thanks GRR) this is underway. While not a great fan of regulation, common standards I always believe to be useful, so perhaps some principles-based standards would be a very useful thing here.

Anyway, happy new year. My wishes for this year are:

  1. May we get better risk management from our banks;
  2. Less regulation from the regulators; and
  3. More principles-based standards to follow.

I also believe porcine aviation will make great leaps this year. If you have any similar wishes, feel free to add them in.

Interesting publication from the Markets Committee of the BIS yesterday. It does a pretty full comparison of the practices of 16 of the major world central banks, covering what their targets are, how they carry out any prudential functions they have and lots of information on how they carry out their other duties.

The 16 covered are the members of the committee: Reserve Bank of Australia, Central Bank of Brazil, Bank of Canada, People’s Bank of China, Eurosystem (European Central Bank plus the national central banks of Belgium, France, Germany, Italy, the Netherlands and Spain), Hong Kong Monetary Authority, Reserve Bank of India, Bank of Japan, Bank of Korea, Bank of Mexico, Monetary Authority of Singapore, Sveriges Riksbank, Swiss National Bank, Bank of England and Federal Reserve Bank of New York.

It is a very useful start for anyone researching the operations of the central banks and for general information on them.
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(Updated – link changed so you do not have to go hunting through the site from the press release. Thanks Sadashiv)

Malcolm Knight, General Manager of the Bank of International Settlements, gave a speech last Thursday to the 2nd Islamic Financial Services Board Forum, outlining how the IFSB, the BIS and the BCBS are working together on developing the institutional framework for the globalisation of Islamic Finance. He emphasises the areas the conventional and Islamic finance have in common – the needs for sound risk management, corporate governance and capital adequacy.

All I can do is encourage those interested in the area to read it.

Abstract:

Although there are differences between Islamic banking and “conventional” banking, there are some fundamental principles that apply equally to both. In particular, rigorous risk management and sound corporate governance help to ensure the safety and soundness of the international banking system. In the light of the growing importance of Islamic banks and Sharia-compliant financial innovation, the increasing integration of Islamic financial services into global financial markets serves to strengthen this point.

The Basel II framework improves the risk sensitivity and accuracy of the criteria for assessing banks’ capital adequacy. This framework is fundamentally about stronger and more effective risk management grounded in sound corporate governance and enhanced financial disclosure, the importance of which has been underscored by the recent problems that have arisen in the banking industry worldwide. The guidance provided by the Islamic Financial Services Board (IFSB) is a useful contribution to the realisation of these global goals. It will support the establishment of resilient financial market infrastructures and sound and robust core Islamic financial institutions operating according to safe and sound risk management practices.

For those who want to see who we can blame thank for the various pronouncements of the Bank of International Settlements – and actually see what the buildings look like etc. – go here.

I am glad to see someone takes me seriously. Amir from Austrolabe took my suggestion on a Google Maps mash-up and ran with it. The result can be seen here.

He has taken up to nine news feeds and the map then takes a pretty fair guess at where the story relates to. The locations are not always perfect, but most are spot on. The feeds are user selectable, with the BIS feed being the default.

If you have any feedback, suggestions etc., feel free to email using the link on the page or just post them here. If you know of good news links with reliable place names embedded within them he may be open to adding them in.

In the mean time, enjoy – if you find it useful, bookmark it.

Update
First one to work out what building the map considers to be the centre of the world and identify it here in a comment wins a prize.
/Update

Usefull links

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