FSA chairman, Lord Turner, today called for close engagement between global accounting standard setters and those responsible for prudential regulation of the banking sector to address issues arising from the unique systemic nature of banks.
Financial Services Authority (FSA) chairman, Lord Turner, today called for close engagement between global accounting standard setters and those responsible for prudential regulation of the banking sector to address issues arising from the unique systemic nature of banks.
Speaking today at a conference hosted by the Institute of Chartered Accountants of England and Wales (ICAEW) in London, Adair Turner, said: “No other sector of the economy is remotely comparable to banking in its capacity to be a driver of economic volatility rather than a victim of it.” As a result, he argued that banks must be viewed differently from any other sector of the economy, including the rest of the financial sector, and that accounting standards relevant to banks need to reflect these differences.
He highlighted two aspects of existing bank accounting practice which contribute to the problem of procyclicality and are, therefore, intrinsically tied to macro-prudential and macroeconomic concerns:
* First, the accounting treatment of loan losses within the banking book. This bases loan loss provisions on evidence of already current credit impairment and does not allow for reasonable judgements on future potential losses.
* And second, the ‘fair value’ valuation approach (predominantly ‘mark-to-market’) in the trading book, which recognises unrealised gains or losses and which, especially when applied to illiquid securities, can drive harmful volatility in both upswings and downswings.
In respect to the first, Adair Turner welcomed the increasing dialogue between the International Accounting Standards Board (IASB) and prudential regulators, and highlighted in particular the IASB’s consultation on a new version of IAS39, which would require loans on balance sheet to bear an ‘economic loss’ provision, rather than recognising losses solely according to the existing incurred loss approach. Adair Turner commented: “In principle this approach has merit, but the devil is very much in the detail and, in particular, in the detail of how ‘economic loss’ will be calculated.”
If calculation of economic loss referred to current market expectations of future losses, there is a danger this becomes mark-to-market by another name, creating even greater procyclicality than in the past.
In respect to the trading book, Adair Turner recognised that there is no alternative to mark-to-market accounting for some instruments, that there is information which shareholders should logically value in mark-to-market accounts, and there is a danger in allowing the freedom to switch accounting approaches to hide problems. Conversely, however, too widespread an application of mark-to-market accounting can exacerbate system volatility.
FSA recommendations:
Faced with these complex considerations, the FSA’s preference would be:
* first, to allow the banking book to reflect a more forward looking approach to loan losses; and
* second, to limit the use of fair value accounting in the income statement to the areas of the trading book where it is most appropriate and, in particular, to trading activities in markets likely to remain highly liquid in nearly all circumstances.
Banking book:
Ideally, the FSA has argued for two separate lines of account information on loan loss provisions: the existing line, as now, and a separate line based either on a formula, as in Spain, or on the judgements of management, challenged by regulators, and with the details, basis and rationale for that judgement extensively disclosed. If this ideal approach is not followed, careful disclosure of the judgements made in the development of the single ‘economic loss’ line will be essential.
Trading book:
In parallel with the regulatory agenda focused on higher capital requirements against trading books, there should be consideration of the appropriate criteria for inclusion of assets within trading books for accounting purposes. In general, this should ensure that the trading book fair value approach is only applied where instruments are liquidly traded and likely to be liquidly tradable in almost all conceivable circumstances.
Adair Turner concluded: “Banks are different because they matter more, because they can do more harm. That’s why we regulate and supervise their businesses but don’t regulate the businesses of retailers or hoteliers or manufacturers. That’s why there is a special relationship with central banks as lender of last resort. That’s why we worry a lot about banks which are too-big-to-fail.
“And that’s why prudential regulators, central banks and economic policymakers have a vital interest in the decisions of accounting standard setters in relation to bank accounting standards, which does not apply between regulators and accounting bodies in any other sector of the economy.”
