IFRS and Basel Accord: main objectives and key priorities Ian Michael ICAEW Manager, Risk and Regulation, Financial Services Faculty
Accounting for financial instruments
The project to replace IAS 39 Project phase Classification & measurement of financial assets Classification & measurement of financial liabilities Impairment methodology Hedging Exposure draft July 2009 May 2010 November 2009 Supplement January 2011 December 2010 Finalisation IFRS 9 published in November 2009 Added to IFRS 9 in October 2010 2011 Q3 2011 Q3 Asset & liability offsetting January 2011 2011 Q3 As at 13 May 2011 3
IAS 39 financial assets Loans & receivables Fixed or determinable payments Not quoted in an active market Initial measurement Subsequent measurement Held to maturity Fixed maturity Positive intent & ability Often long-term Available for sale Sell as and when Often medium to long-term Includes transaction costs Amortised cost Fair value with gains & losses to equity At FV through P&L Held for trading Often short-term Excludes transaction costs Fair value with gains & losses to profit or loss 4
IAS 39 reclassifications Loans & receivables Fixed or determinable payments Not quoted in an active market Held to maturity Fixed maturity Positive intent & ability Often long-term Available for sale Sell as and when Often medium to long-term At FV through P&L Held for trading Often short-term Debt Debt or equity 5
IFRS 9 financial assets Contractual cash flow characteristics + Business model test Amortised cost One impairment method Fair value option for accounting mismatches only All other instruments Equities, derivatives & some hybrid contracts Fair value through P&L No impairments Option to take gains & losses to OCI for equities Classify into a measurement category at inception Reclassification required where business model changes. 6
Impairment of financial assets Incurred loss model Currently used by IAS 39 Credit losses are recognised only if an event has occurred that has a negative effect on future cash flows & that effect can be reliably estimated An entity is not permitted to consider the effects of future expected losses Expected loss model Proposed in recent ED Requires an entity to make an ongoing assessment of expected credit losses May require earlier recognition of credit losses Supplement published in January 2011 addressing main operational issues of the ED 7
Exposure draft: expected loss model Net interest Interest income initially recognised based on 10% effective interest rate Credit loss recognised following trigger event Interest income recognised at 7% reflecting the expected credit loss over the life of the instrument Expected loss model Time Incurred loss model 8
Supplement: expected loss model LOAN LOSS ALLOWANCE Receive regular payments Recovery Credit risk management objective Good book Bad book Higher of Time-proportional amount of losses for the remaining life; and Expected losses in the foreseeable future All expected credit losses 9
IAS 39 & IFRS 9 - financial liabilities Most of the requirements carried forward unchanged from IAS 39 Held for trading including derivatives that are liabilities Fair value through P&L Vanilla liabilities Amortised cost Hybrid instruments Bifurcation Maintains fair value option but with one amendment regarding own credit risk 10
Exposure draft: asset and liability offsetting Key proposals Offset required where There is an unconditional and legally enforceable right of set-off; and The intention to settle on a net basis or realise simultaneously Offsetting required for both bilateral and multilateral set-off arrangements Enhanced disclosures 11
Exposure draft: hedging Proposes a new general hedge accounting model. Aim is to better reflect risk management activities in the financial statements. Basic concepts of IAS 39 retained ie, fair value hedges, cash flow hedges etc but proposed rules regarding what items can qualify for hedge accounting, what can be a designated hedging instruments and effectiveness testing are generally more relaxed. Many hedging relationship that do not qualify for hedge accounting under IAS 39 would qualify under the proposals. Separate proposals on portfolio hedging expected later in 2011. 12
Other IFRS projects
Recently completed projects Package of five standards Standard IFRS 10 Consolidated Financial Statements IFRS 11 Joint Arrangements IFRS 12 Disclosure of Interests in Other Entities IAS 27 Separate Financial Statements - revised IAS 28 Investments in Associates and Joint Ventures - revised IFRS 13 Fair value measurement Details Replaces SIC-12 & parts of IAS 27 Replaces IAS 31 Updated disclosure requirements for all forms of interests in other entities The requirements relating to separate financial statements are unchanged. Amended for conforming changes Provides in a single standard a framework for measuring fair value 14
Interaction between IFRS 9,10,11,12 & IAS 28 Yes Control alone No Consolidate in accordance with IFRS 10 Disclosures in accordance with IFRS 12 Yes Joint control No Define type of arrangement per IFRS 11 Significant influence Joint operation Joint venture Yes No Account for asset, liabilities, revenues & expenses Disclosures in accordance with IFRS 12 Account for an investment in accordance with IAS 28 Disclosures in accordance with IFRS 12 IFRS 9 15
IFRS 13 - a new definition of fair value Based on exit price rather than entry price, regardless of whether the entity plans to hold or sell the asset The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date Principal or most advantageous market Highest and best use 16
IFRS 13 - a fair value hierarchy The hierarchy categorises the inputs used in valuation techniques into three levels 1. Quoted market prices for identical assets or liabilities in active market eg, unadjusted quoted market prices for traded securities 2. Directly or indirectly observable inputs other than market prices within level 1 eg, quoted prices for similar assets or liabilities in active markets 3. Unobservable inputs eg, use the best information available in the circumstances Fair value measurement is categorised in its entirety in the level of the lowest level input that is significant to the entire measurement 17
Other ongoing projects Project Amendment to IAS 1 Amendment to IAS 19 Revenue recognition Leases Insurance contracts Status Presentation of OCI Post-employment benefits ED issued ED issued ED issued Estimated completion May 2011 June 2011 2011 Q4 2011 Q4 2011 Q4 As at 13 May 2011 18
Basel Accord
Basel III - Introduction Lots of regulatory reform Lots of interested parties Main issues Quality of capital Excessive leverage Capital buffers to be maintained Calibration and risk coverage Insufficient liquidity 20
High level impact 0-100% Risk weighted assets increase 10 60% Common equity decrease due to deduction changes X 3.25 Common equity (Core T1) ratio increases Approx 50% Long term funding shortfall Source: KPMG analysis of various broker reports 21
Capital and liquidity Prudential requirement firms must hold adequate financial resources Capital Quantitative international standards Basel 1Accord - 1988 Basel 2 Accord -2007 Pillar 1 Pillar 2 CRD Historic regulatory focus Liquidity Qualitative BCBS paper: sound practices for managing liquidity in banks (2000) CRD (Capital Requirements Directive) Annex V Quantitative previously no agreed international standard Overdue rebalancing BCBS has proposed two minimum requirements: Liquidity coverage Net stable funding ratio 22
Structure of the reform proposals Basel III Capital reform Liquidity standards Systemic risk and interconnectedness Quality, consistency and transparency of capital base Capturing all risks Controlling leverage Buffers Short term: liquidity coverage ratio (LCR) Long term: Net stable funding ratio (NSFR) Capital incentives for using CCPs for OTC Higher capital for systemic derivatives Higher capital for interfinancial exposures Contingent capital Capital surcharge for systemic banks 23
Timeline for implementation Leverage CE Conservation Buffer Deductions from CET1 T1 Supervisory monitoring Parallel run Disclosure Migration to Pillar I 3.5% 4.0% 4.5% 0.625% 1.25% 1.875% 2.5% 20% 40% 60% 80% 100% 4.5% 5.5% 6.0% Phase-out of capital instruments LCR Observation period Beginning 2013 for 10 years Introduce minimum standards NSFR Observation period Introduce minimum standards 2011 2012 2013 2014 2015 2016 2017 2018 2019 24
Key changes Longstanding 8.0% Basel minimum ratio increases to 10.5%, including 2.5% capital conservation buffer Of this a minimum of 7.0% (including capital conservation buffer) will have to be in the form of common equity Possibility of minimums being raised a further 2.5% when countercyclical buffer triggered by excessive loan growth Also possibility of further add-on for systemically important banks New 3% leverage ratio & 30-day liquidity coverage ratio confirmed Phased implementation: changes to capital formally begin 2013; but new leverage & liquidity ratios soft-launched sooner (2011) Major banks in Europe should find it possible to comply with these new numbers but may need a significant revamp of capital management, liquidity risk management, stress-testing, & ICAAP 25
Basel capital ratios as at 2019 Minimum 10.5% of RWA (incl. buffer) Tier 1 Buffer Tier 2 Buffer Buffer Buffer Total Tier 1 capital (min. 6% ) Common equity (min. 4.5%) 2.5% Conservation buffer (common equity) Tier 1 + Tier 2 capital minimum 8% Pillar 2 risks (unquantified) 0-2.5% Countercyclical buffer 0-?% Additional buffer for systemically important banks Source: Basel Committee 26
Minimum common equity Increased from 2.0% to 4.5% Plus capital conservation buffer of 2.5% Bringing total common equity requirements to 7.0% To be phased in from 2013 to 2019 Assessment: In principle, banks will be able to draw on the buffer during periods of stress, but it seems unlikely that they would choose to do so, given the associated constraints on their earnings distributions Consequently, banks are likely to target a higher common equity ratio 27
Minimum total capital Increased from 8.0% to 10.5% (including conservation buffer) To be phased in from 2013 to 2019 Assessment: Prospect of further add-ons for: Pillar 2 risks (unquantified) Systemically important banks (unquantified) Countercyclical capital buffer (0-2.5%) Given likely desire to avoid using capital conservation buffer, banks may target a total capital ratio of perhaps 12.0-13.0% (10.5% plus 1% or so for Pillar 2 risks, plus another 1% or so safety cushion) When the countercyclical capital buffer is triggered, this could rise to 15.0% or more 28
Tighter definition of capital Tier Tier 1 capital (going concern) Tier 2 capital (gone concern Tier 3 capital Component Common Shares (and retained earnings) Additional Going Concern Features Criteria applicable also for non-joint stock companies Predominant form of Tier 1 Innovative hybrid capital elements will be phased out Capital definition also applicable for leverage ratio Discretionary payments Not contributing to liabilities exceeding assets Able to bear losses in going concern Harmonisation through minimum entry criteria Limitations on callability and minimum maturity Removal of Tier-1 based cap Ineligible instruments will be phased out Abolished 29
Tighter definition of capital Phasing out of non-standard Tier 1 over 10 years beginning 2013 Tighter treatment of deductions (minority interests, investments in other financial institutions, deferred tax assets) Assessment: Markets/investors already discounting such issues; likely that banks will want to clean up ASAP Likely to see significant capital-raising by banks in coming years Banks likely to keep dividend payout ratios low to conserve reserves 30
Leverage ratio A minimum ratio of Tier 1 capital to total assets of 3% will be tested. Includes: On-balance sheet positions Off-balance sheet items and derivatives To be monitored from 2011 & more formally introduced from 2013 It will become a formal Pillar 1 requirement in 2018 Assessment: This will limit total assets to 33 times Tier 1 capital (compared with the limit of risk-weighted assets to Tier 1 capital of around 11 times) It remains to be seen whether this limit will bite in many cases Market pressure to have capital > 3% Potential incentive for higher risk, higher return lending 31
Liquidity New liquidity coverage ratio (LCR) will be monitored from 2011 & formally introduced in 2015 This requires the bank to carry a stock of high quality liquid assets to enable it to survive a 30 day stress scenario Proposed net stable funding ratio not formally introduced until 2018 Assessment: All the focus initially will be on the short-term ratio Potential issues with the LCR include: Relevance to some markets of 30 day horizon & run-off rates Reduction in profitability Return on short term assets will decrease while cost of long term assets will increase significantly Availability of sufficient government debt in some markets 32
Further work in progress prudential regulation Topic Use of external ratings Contingent capital Large exposures Systemic firms Status Standardised approach and Securitisation treatment still uses external ratings Due diligence requirements for securitisation exposures introduced EU Credit Rating Agency Regulation introduced in 2009 BCBS consultation paper in August 2010 Few banks have issued COCO type instruments CRD 2 finalised and implemented across EU from 31/12/2010 FSB published recommendations for supervision of SIFIs in November 2010 FSA publishes discussion paper on dealing with systemic firms in October 2009 Next steps BCBS reviewing approach for securitisation capital requirements and associated cliff effects by end-2011 EU consulting on further review of Credit Rating Agencies BCBS to complete its proposals by mid-2011 BCBS to review international range of LE rules to strengthen guidance BCBS to develop approach for identifying SIFIs by end-2010 BCBS to develop proposals for additional capital for SIFIs by mid-2011 33
Summary of likely impact of Basel III Impact on banks Diversity of banking models will be reduced Profitability and RoE under pressure Potential competitive disadvantage for Basel 3 based banks Less demand for current accounts funding Less appetite to offer LT-financing Significant demand for longer term funding Corporate restructuring of banks (including transactions) Impact on wider economy Reduced risk of a systemic banking crisis Lending capacity of banking sector will be reduced Low risk (mortgage) lending will become more expensive Less appetite from investors to invest in bank equity / debt as: Dividends will be required to build up capital base RoE and profitability under pressure Some debt will become loss absorbing Next steps Reassessment of business model (including definition of future key products) Define strategy to restructure balance sheet Define operating model and size of workforce and system landscape Develop strategy to increase stable funding / raise capital (incl. funding plan) Liquidity measurement Implementation of B-3 reporting systems / measurement tools / governance 34
Links between IFRS and Basel III
Links between IFRS and Basel III (1) Valuation Valuation critical to measurement of capital Fair valued items: IFRS 13 Fair Value Measurement Basel text envisages prudent valuation adjustments for regulatory purposes Amortised cost assets: it s essential loan loss provisioning is adequate, otherwise capital would be overstated (2) Technical interaction of provisioning with internal models capital calculation Will it still be appropriate to treat accounting provisions in excess of Basel Expected Loss (EL) as part of capital? 36
Links between IFRS and Basel III, continued (3) Consolidation In practice accounting consolidation influences the regulatory approach to individual firms. So IFRS 10 Consolidated Financial Statements important to banking supervision. (4) Offsetting (netting) Leverage ratio uses Basel II netting rules. These rules are closer to US GAAP than to current IFRS. (5) Hedging Important that accounting standards facilitate financial statements showing the economic substance of the hedging arrangements in place. IASB recognises this. 37
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