Old arguments

Criticisms that Basel II is pro-cyclical are nothing new. Ever since the Accord was little more than a glint in the eye of the Basel Committee on Banking Supervision, observers have argued that the requirement to set risk weightings based on credit quality means capital would rise in a downturn, potentially forcing banks to cut back on lending and exacerbating any recession.

The debate has continued for years, but the severity of the financial crisis has sparked a flurry of activity. Last month, the Basel Committee confirmed it would introduce rules to promote the build-up of capital buffers that can be drawn down in periods of stress, while the UK Financial Services Authority also put forward the idea of a capital buffer in the Turner Review.

In doing so, however, regulators are potentially locking horns with the accounting standards bodies. Currently, loan loss provision rules stipulate there must be objective evidence of impairment before a provision can be made. General provisions or reserves are not allowed, unless these are an attempt to estimate loan losses after a triggering event has actually occurred.

Regulators argue this is pro-cyclical: in good times, provisions will be low, even though banks may recognise losses are likely to increase in future, but in bad times, banks have to throw money into mushrooming loan loss provisions to cope with rising impairments. The counter argument from accountants is that financial statements should reflect the current condition of a firm - and as the behaviour of borrowers is cyclical, any accounting model must also inevitably be cyclical. Any attempt to smooth the effects of the cycle through a fund or provision would mean the resulting financial statements do not reflect the economic characteristics of loans in the portfolio.

Again, this argument between regulators and accountants is nothing new. But the difference now is that political pressure to strengthen bank capital has reached a frenzy. Some regulators are adamant any capital buffer should be reflected in published accounts, as well as in calculations of required capital, and that pro-cyclicality should be eradicated from accounting standards. Something has to give. Given the public interest, it is not impossible to imagine strong political pressure being placed on accounting standard setters to tweak their rules.

Before they do, fundamental questions need to be asked over what accounting rules are trying to achieve. If it is agreed the purpose of any accounting model should be a measure of the here and now - to give shareholders an indication of what would be available to them if the firm were to collapse today - the main protagonists should resist the urge to make major alterations. In reality, some form of compromise seems most likely.

Nick Sawyer, Editor.