Advanced Program in Accounting and Auditing Regulation Module 23

1. Advanced Program in Accounting and Auditing RegulationModule 23 Prof. Arnold Schilder Chairman BCBS Accounting Task Force 3 May 2006

2. Agenda • Interaction between financial reporting and prudential reporting • IFRS and prudential reporting • Bridging the gap: filters, guidance, templates • IAS 39: supervisory response • Impact on regulatory capital • Loan loss allowance guidance • Work ahead • Need for robust audit: recent initiatives

3. Overview • The information that prudential supervisor needs is not always available from the financial reporting (= the published financial statements) • Completely separate prudential reporting is expensive and can result in internal control risks and behavioural risks • Therefore: use financial reporting as much as possible

4. IFRS and prudential reporting • Financial reporting is becoming more risk-sensitive • IAS 39 (recognition and measurement of (innovative) financial instruments, (collective) loan loss allowances), IAS 32 (presentation of innovative instruments), IFRS 7 (financial risk disclosures), consolidation of innovative financial structures • The regulatory capital framework is also becoming more risk-senstive • Pillar 1 (IRB-approach, operational risk), Pillar 2 assessment, Pillar 3 disclosures • But…

5. IFRS and prudential reporting • … there are differences in risk perception… • Financial reporting takes a neutral view of risk; prudential reporting focuses on downside risk • Financial reporting is moving more slowly towards recognising portfolio risk and portfolio risk management • Financial reporting is moving towards a shorter time horizon; the focus is increasingly on what is now

6. IFRS and prudential reporting • … and differences in risk measurement • Financial reporting is moving towards more flexible measurement principles • Increased use of fair values; also for illiquid financial instruments • IAS 39 fair value option (FASB fair value option proposal) • Financial reporting differentiates risks less explicitly than prudential reporting • Regulatory capital is computed using explicit risk weightings

7. IFRS and prudential reporting • … and differences in presentation • Financial reporting is becoming less specific in form • No specific standard for banks • No specific reporting formats

8. Bridging the gap • Prudential filters: adjust financial reporting to (1) eliminate artificial volatility; (2) maintain level of regulatory capital • Prudential guidance: complement financial reporting to support prudential reporting (e.g. fair value option, loan loss allowances) • Prudential reporting templates: complement financial reporting to support prudential reporting (e.g. FINREP, COREP)

9. Prudential filters • Eliminate artificial volatility • Reverse fair value gains and losses on liabilities for banks’ own credit standing • Reverse fair value gains and losses on cash flow hedges

10. Prudential filters • Maintain level of regulatory capital • Examples: • Deduct goodwill • Maintain prudential framework for: (1) classification of debt versus equity; (2) trading book; (3) securitisations • Reallocate fair value gains and losses between Tier 1 and Tier 2 capital

11. Prudential guidance • Prudential filters not preferred route in all cases • Exploit strengths of financial reporting • Recognise reporting burden on banks • Apply prudential guidance where this solves the problem • Accept financial reporting if subject to robust risk management consistent with prudential norms • If not, consider prudential measures

12. Prudential reporting templates • FINREP (FINancial REPorting framework): based on IFRS • COREP (COmmon REPorting framework): based on CRD • Promote convergence of supervisory practices • Promote harmonisation of information • Facilitate exchange of information • Reduce reporting burden on banks operating cross-border

13. Agenda • Interaction between financial reporting and prudential reporting • IFRS and prudential reporting • Bridging the gap: filters, guidance, templates • IAS 39: supervisory response • Impact on regulatory capital • Loan loss allowance guidance • Work ahead • Need for robust audit: recent initiatives

14. Overview • IAS 39 has merits and drawbacks for the prudential supervisor • Supervisory response is necessary • IAS 39 is an ongoing project

15. Impact on regulatory capital • Qualitative analysis indicated need for response • Press releases (prudential filters) • Prudential guidance (fair value option, loan loss allowances) • Quantitative analysis (CEBS) indicated need for monitoring • Fair value option • Loan loss allowances • Hedge accounting

16. CEBS impact analysis (transition) In billions of euros

17. Regulatory response: why? • Prudence: forward-looking recognition of losses; critical recognition of gains • Reliability: measurement of non-traded instruments • Economic risk recognition:volatility; portfolio risk (management) • Definitions: eligible capital instruments, trading book, securitised assets

18. Regulatory response: what? • Prudential filters (treated earlier) • Prudential guidance • Fair value option guidance (under consultation) • Loan loss allowance guidance (under consultation)

19. Loan loss allowance guidance (1) • Purpose of the guidance • Highlight principle of robust loan loss allowances under financial reporting standards • Provide guidance for evaluating loan loss allowances from a prudential perspective • Highlight need to act when loan loss allowances do not satisfy prudential norms

20. Loan loss allowance guidance (2) • Content of the guidance • Ten principles covering • Supervisory expectations • Supervisory action • Highlight differences between financial reporting framework and prudential framework • Encourage use of common inputs for credit risk assessment, financial reporting and prudential reporting

21. Loan loss allowance guidance (3) • Implementation of the guidance • Identify when to recognise loan losses • Determine how to calculate loan losses • Analyse loan losses against prudential norms • Integrate data and processes to the extent possible • Manage separate data and processes from point of divergence

22. Loan loss allowance guidance (4) • Implementation of the guidance • Process review • Dialogue with external auditor • Dialogue with prudential supervisor • Dialogue between external auditor and prudential supervisor

23. The work ahead: short-term • Monitor application of fair value option on banks’ capital base and business practices • Monitor level of banks’ loan loss allowances under IAS 39 • Monitor developments in fair value measurement project (including fair value hierarchy) • Remain open to initiatives to refine the IAS 39 hedge-accounting framework

24. The work ahead: long(er)-term • Address fundamental issues to accommodate broader stakeholder base • Conceptual framework project is first contribution • Key aspects for consideration include: • Risk sensitivity: economic risk recognition • Risk perception: forward-lookingness • Risk measurement: reliability • Feasibility and cost of application and enforcement

25. Agenda • Interaction between financial reporting and prudential reporting • IFRS and prudential reporting • Bridging the gap: filters, guidance, templates • IAS 39: supervisory response • Impact on regulatory capital • Loan loss allowance guidance • Work ahead • Need for robust audit: recent initiatives

26. Overview • Regulatory framework relies on audit (reliable reporting) • Audits must be performed, and be perceived to performed, independently and to a high quality • Improvements in audit have been made • There is room for further improvement

27. Interaction with regulatory framework • Prudential reporting (which is based on financial reporting inputs) relies on reliable information (e.g. application of financial reporting standards (fair values, loan loss allowances)) • Market discipline (including Pillar 3) relies on reliable information

28. Recent initiatives in audit • Regulatory intervention • Introduction of oversight: PCAOB (US), EGAOB (EU) • Revised legislation (EU 8th Directive)

29. Recent initiatives in audit • IFAC institutional reform • Introduction of oversight: PIOB with strong regulatory input • New CAG with independent chair and pro-active Working Groups • Stronger focus on public interest: • International Auditing and Assurance Standards Board (IAASB) • International Accounting Education Standards Board (IAESB) • International Ethics Standards Board for Accountants (IESBA)

30. Recent initiatives in audit • IFAC technical reform • Revised Code of Ethics • Clarity Project • Review of standards • Explicit identification of public interest entities • Focus on conduct, including corporate conduct

31. EU 8th Directive • Formal adoption foreseen in 2006; transposition into national law within two years • Independent public oversight • Auditor independence (audit vs non-audit services) • Mandatory rotation (key audit partner; public interest entities; every 7 years at the latest) • Requirement for listed companies to set up audit committee or equivalent body • Limited liability (EC invited to issue report before end 2006)

32. The way ahead • BCBS applauds efforts so far • Areas for ongoing improvement • PIOB focus: Balanced composition of IFAC boards, public accountability, quality of audits worldwide • Technical improvements: Clarity Project, ethics, review of IAPS 1006 (auditing the financial statements of banks) • Specific focus on interactive tools such as XBRL (financial and prudential reporting) • Continuing dialogue between regulators and audit profession • Continuing dialogue among regulators