Impact of IFRS on banks and longer term linkages between FVA & financial stability

1. Impact of IFRS on banks and longer term linkages between FVA & financial stability Presentation to the CEPS Mauro Grande Brussels, 22 November 2005

2. Overview • Scope of presentation • ECB contribution to the debate on full FVA • Potential benefits and concerns from FVA in the banking sector • Way forward

3. A. Scope of presentation

4. Scope of presentation Focus on the link between Fair Value Accounting (FVA) and financial stability: • The main interest of the ECB (and central banks in general) is related to possible financial stability implications of accounting standards • It may be early to assess the full impact of IFRS on banks’ financial statements • Perception that it is only a matter of time for accounting standard setters to adopt full FVA

5. Scope of presentation The IASB is expected to move towards full FVA “The Board is committed to work towards a replacement to IAS 39. A replacement standard could be a full fair value model or an improvement on the mixed attribute model.” David Tweedie, Chairman IASB, Jul. 2005 “The IASB is focused on fair value because fair value accounting is the only comprehensive and internally consistent approach it has identified to improve financial reporting” Mary E. Barth, IASB & Graduate School of Business Stanford University, Nov. 2005

6. B. ECB contribution to the debate on full FVA

7. ECB contribution • Analytical work on linkages between full FVA and financial stability (ECB MB Feb 2004 and ECB Occasional Paper no. 13, Apr 2004) : • Focus was on the financial stability implications of a move in the banking sector from the current accounting framework to full FVA. A simulation exercise was performed on how various external shocks affect the balance sheet of an average European bank under the two frameworks • The conclusion is that the introduction of full FVA could have a significant effect in terms of income volatility, pro-cyclicality of bank lending and more general financial stability. Hence, any move towards a full FVA framework should be gradual • Further analysis under way

8. ECB contribution • Policy input in the finalisation of IAS 39 (fair value option) - Contribution by the ECB focused on IAS 39 Financial instruments: recognition and measurement given its importance for the banking sector. In particular the ECB addressed the unrestricted use of the fair value option introduced in the standard in December 2003 - IASB issued an ED on the FVO in July 2004. FVO was restricted to a specific number of typologies. Carving-out clause by the Commission • Amendmentsto IAS 39 regarding the FVO in June 2005 introducing a principle-based approach. They were supported by ECB, regulators and industry. Removal of carving-out clause by the Commission • A concrete example of how various constituencies worked together to arrive at a consensual solution

9. C. Potential benefits and concerns from FVA in the banking sector

10. Potential benefits • Fair values are inherently forward-looking and can thus result in a timelier recognition of risks which in turn may establish incentives to improve risk measurement and management practices • This is the case for derivatives instruments in the banking book for which fair value brings the exposure to these instruments which are normally complex and highly leveraged to the balance sheet • For trading instruments held in liquid markets, fair value provides the most relevant and useful information to users • FVA is normally coupled with increased disclosurerequirements which reinforce market discipline. Evidence so far shows that disclosure reduces bank equity price volatility (Baumann and Nier, 2004) and earnings forecast uncertainty (Ammer et al. ,2005)

11. The reliability of fair values can be questioned when the instruments are illiquid or the institution holds a ‘block’ holding For non-traded illiquid instruments marking-to-model may result in highly subjective values difficult to verify (by auditors, markets or supervisors) The revenue recognition of potentially unreliable fair values may give a false perception of increased profitability to the market and would be apt for distribution, effectively depleting the bank’s capital base Fair value may not reflect relevant information. Instruments held to maturity (i.e. majority of loans) “pull to par’’ at maturity (i.e. value at maturity = nominal value) irrespective of swings in the fair value during the lifetime of the instrument Potential concerns

12. Full FVA may lead to ‘artificial volatility’ in markets, i.e. volatility not justified by economic ‘fundamentals’ but driven by short-term fluctuations from ‘noise’ in the markets (i.e. rumours). Research shows that the risk of ‘artificial volatility’ is at its greatest when claims are long-term, illiquid and senior (Shin et al., 2004). These are the main attributes of key balance sheet items of banks and insurance companies Full FVA may not reflectbusiness models of financial institutions and could make planning horizons shorter term and alter behaviour Potential concerns

13. The fair valuation of own liabilities and the recognition of ‘own credit risk’ intends to recognise an accounting gain relating to a deterioration of the institution’s creditworthiness In a situation of distress, it is very unlikely that through a buy-back the potential gain could materialise The potential gain could provide the market with misleading information on profitability and may create incentives for institutions to take on further risk Potential concerns

14. Still ‘early days’ to assess the concrete impact on financial stability from an increasing usage fair values not only for trading instruments but also for traditional ‘banking book’ items. Concerns and benefits are still tentative, given the limited evidence Emergence of new instruments, the continued development of IT, risk measurement and pricing techniques might change the current landscape and further the development of deep and liquid secondary markets (e.g. markets for trading credit) thus reducing some concerns of full FVA Overall assessment

15. D. Way forward

16. How can the financial stability concerns be addressed? Part of the general question as to whether accounting standards should satisfy the needs of all interested constituencies (investors, corporate treasurers, market analysts, external auditors and prudential supervisors/central banks) To a certain extent, accounting standard setters should try to reconcile the different interests, including financial stability. For the latter, the underlying assumption is that reliable and relevant financial information is important not only for the efficient functioning of the financial system but also for its stability which is a public good To the extent that accounting standards cannot take fully into account the financial stability concerns, the competent public authorities (supervisors and central banks) will have to take care Way forward

17. What can be done by the accounting standard setters? Recognize that fair value calculations have limitations. Marking-to-model should be subject to clear requirements on the parameters and methodologies, strict controls and ample disclosure Extend accounting information by complementing the figures of current financial information with (i) estimates on the risk profiles and (ii) measures of the uncertainty related to the estimates (BIS 2005) Way forward

18. What can be done by the public authorities responsible for financial stability? Supervisors have developed ‘prudential filters’ that adjust the calculation of Own Funds so as to maintain their current definition and quality These prudential filters are relevant alsofor central banks since the aggregate information used by them for their financial stability assessment is largely based on prudential data Central banks can use filters also for their monetary policy purposes Way forward

19. Thank you for your attention!