The Use of IFRS for Prudential and Regulatory Purposes

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1 REPARIS A REGIONAL PROGRAM The Use of IFRS for Prudential and Regulatory Purposes IASB works - IAS 39 THE ROAD TO EUROPE: PROGRAM OF ACCOUNTING REFORM AND INSTITUTIONAL STRENGTHENING (REPARIS)

2 Background on IAS 39! IFRS: International Financial Reporting Standards equivalent to IAS: International Accounting Standards! Different names due to change in names of standard setter IASB (International Accounting Standard Board)! IAS 39 deals with accounting treatment of financial instruments: derivatives, equities, debt for assets and liabilities! IAS 39 prescribes the accounting treatment (FV, amortised costs, gains/losses through reserves or P&L)! IAS 39 applicable since 2005! Before many of these instruments remained off-balance sheet, now they are on-balance sheet and within the scope of the IAS 39! IAS 39 was amended during the crisis 2

3 Background on IFRS 7! Disclosures related to IAS 39 are prescribed in IFRS 7! Disclosures about risks in financial instruments: Market risk, credit risk and liquidity risk! Qualitative and quantitative disclosures! One of the key criteria for IFRS 7 disclosures is: seen through the eyes of management but it makes financial statements less comparable! IFRS 7 was amended during the crisis! There are also some disclosure requirements related to financial instruments in IAS 1, e.g. assumptions made re. valuations 3

4 IAS 39 - classifications for assets! 4 categories! Held at fair value through P&L: e.g. derivative instruments! Available for sale (AFS): gains and losses through equity! Loans and receivables: amortised cost! Held to maturity: amortised cost! Before the crisis cannot change or reclassify once decision is made but during the crisis reclassifications were permitted! Decision is also based on management intentions, ie whether for trading activities or to hold on to maturity! Can be complex for non-initiated! Held to maturity rarely used because of tainting rules 4

5 IAS 39 - Fair value through P&L! Held at fair value through P&L! Gains and losses through P&L! No impairment as losses (or gains) calculated regularly through changes in fair value! Also known as held for trading! Generally derivatives should be accounted for in this category! A fifth category FVO: fair value option! FVO treatment is same as held at fair value through P&L! Some banks disclose the FVO under the designated at fair value 5

6 IAS 39 Available for sale (AFS)! Instruments in this category are also measured at FV! Gains and losses are are through Other Comprehensive Income OCI (equity)! When position is closed, gains and losses are taken through P&L! If assets are impaired: losses are taken to P&L! Sometimes difficult to distinguish between losses and impairment, can be subjective! Example: AFS equity is impaired if: Objective evidence of impairment e.g financial difficulty, bankruptcy, etc. Or there are significant changes in legal, economic, technological changes! AFS debt instrument is impaired only if above applies and If losses are significant and prolonged Significant and prolonged are not defined 6

7 IAS 39 AFS impairment! Reversal of impairment is allowed if fair value improves but AFS debt: past impairment should be reversed through P&L AFS equity: past impairment should be reversed through equity! Regulatory approach! Prudential filter Prudential filter is applied to unrealised gains/losses on AFS debt No prudential filter on AFS equity in some countries! Do you have this prudential filter in your jurisdiction? (5 mins) 7

8 IAS 39 - Loans and Receivables! At amortised costs! Used when difficult to obtain the price! Impairment test is still applicable! Allowed to use FVO but should be at inception only If FVO is used, the instrument e.g. loan is measured at FV! Loans and receivables mainly used for retail banks loan portfolios! What examples of loans and receivables have you seen in the banks you supervise? (5 mins) 8

9 IAS 39 Held to Maturity (HTM)! At amortised cost! Impairment test is still applicable! Non-derivative instruments! Intends to and able to hold to maturity! Firms are allowed to use FVO but at inception only! Currently HTM is not much in use because of tainting rules (among other things) If a bank sells part of a HTM portfolio, all the bank s HTM instruments should be transferred to available for sale for a period of two years The bank is prohibited from classifying any investments as HTM for the next two years! Tainting rules applied at group level! Why do we have tainting rules? (5 mn) 9

10 Regulatory classifications! Trading book! Banking book! Still used by some practitioners and regulators although IAS 39 classifications are used in the financial statements! Some investment banks do not have a banking book; only a trading book! Some text also refers to banking and trading book e.g. interest rate risk in the banking book! So can be a source of confusion 10

11 Regulatory classifications! Trading book Trading (Fair value through P&L) Also includes some AFS instruments (fair value through reserves) Its not always a perfect match between accounting and regulatory definitions 11

12 Regulatory classifications! Banking book Fair value option Some AFS instruments Loans and receivables (amortised cost) Held to maturity (amortised cost) 12

13 IAS 39 Own credit risk! Changes in own credit risk of an entity could result in a gain or a loss! Gains and losses due to changes in own credit risk hit the P&L! The amount can be quite significant! However, there is a prudential filter! Rating agencies also tend to ignore the gains and losses due to changes in own credit risk! In some jurisdictions, banks are required to disclose the amount in prudential regulatory returns! Also a disclosure requirement in IFRS 7! Questions: Have you seen this disclosure in the financial statements of banks you supervise? Are the amounts significant? 13

14 IAS 39 Three levels for measurement! Disclosures are required for the following instruments measured at fair value Level 1: Quoted market price Level 2: valuation techniques are used; using observable inputs Level 3: Valuation techniques are used; with significant unobservable inputs! The disclosure requirements are in IFRS 7 14

15 IAS 39! Q&A! Review of financial instruments disclosures re. IAS 39 classifications: HSBC and Prudential! Exercise followed by presentations by two groups 15

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