Some bank regulators are planning to drive a coach and horses through the new loan loss standards proposed by the International Accounting Standards Board (IASB), by interpreting the rules in a far more radical way than accountants envisage, says Adair Turner, chairman of the UK Financial Services Authority (FSA).
The IASB's proposals, published on November 5, would replace the current incurred loss model with one based on expected loss, conceding some ground to critics in the regulatory community but disappointing many who had hoped the rules would embrace a dynamic provisioning approach similar to that used in Spain. Turner claims these regulators will seek to squeeze the Spanish model into the confines of expected loss.
"There is tension here. There are regulators around the world that are going to take the IASB's expected loss approach - whatever the IASB says - and require banks to do Spanish-style dynamic provisioning under that," Turner said, responding to an audience question following his keynote speech at an event organised by the Institute of Chartered Accountants in England and Wales (ICAEW) at their headquarters in London on January 21.
Friction between accountants and regulators arises from a fundamental difference in their objectives, which Turner highlighted in his speech: accountants want banks to tell investors how they are performing today, while regulators want firms to hold big reserves for tomorrow. As such, many observers have been anticipating fierce debate over exactly what is meant by expected loss - but Turner's remarks suggest some regulators have simply decided to impose their own view.
Although Turner stopped short of identifying the regulators that might seek to twist the IASB standard, the entire regulatory community is under considerable political pressure to make the banking system less pro-cyclical in light of the severity of losses during the crisis. New provisioning standards could be one way to achieve that. If banks are forced to provision earlier for losses on their loan portfolios, they would theoretically be less likely to have to raise capital - and so rein in lending - when defaults rise during a downturn.
We expect, when we get down to the detail, accountants will not allow that much judgment in a single line item
But accounting experts warn regulators shouldn't look to the new IASB standard to achieve their goals. "Accounts aren't written specifically for regulators - they are general-purpose financial statements for the benefit of users including creditors, regulators, tax authorities, investors, analysts, the public, customers and employees - so it doesn't make sense for standards to be adapted because of regulatory needs. In any case, while the provisioning model the IASB has proposed recognises losses earlier, it is not counter-cyclical so it will not be a solution regulators can use to tackle pro-cyclicality," says Colin Martin, partner in the financial services technical advisory team at KPMG in London.
Although the IASB proposals would force banks to start provisioning for losses as soon as a loan is granted - rather than waiting for a trigger event as under the current incurred loss standard - the size of those provisions will depend on how loss expectations are calculated. Regulators are pushing for the calculation to be based on historical data and to include some assumption of a coming economic downturn - known as a through-the-cycle approach - which would result in plumper provisions. But that would provoke a storm of protest from accountants, who argue such an approach would create provisions for losses that have not happened - and may never materialise.
The IASB has appointed a 25-member expert advisory panel (EAP) to work out how expected loss could be calculated in practice and one member of the group says the first meeting on December 9 went well. "All parties involved want to move this thing forward," he says.
Despite the resistance of accounting standard-setters, regulators remain highly concerned about provisioning, and the Basel Committee on Banking Supervision was last month asked by its oversight board to ensure the creation of a robust provisioning method based on expected losses (see page 9).
"Since this aspect of accounting has major implications for the soundness of banks, supervisors care very much about it and we are very unhappy about the incurred loss approach, which forces a driving-up of provisions at precisely the wrong time. We want to move away from that, but at the same time we want to make sure the expected loss approach works in substance and not just in name," says one senior regulator.
The waters stand to be further muddied in the coming months when the Financial Accounting Standards Board (FASB), the US standard setter, publishes its own proposals, which are expected to call for all financial instruments, including loans, to be reported at fair value - an approach that could introduce even more cyclicality to provisioning. In his ICAEW speech, the FSA's Turner said the FASB "appears to be devoted to fair-value accounting".
While the EAP member says he expects some kind of compromise between accounting standard-setters and regulators, he concedes it would be much harder to achieve peace if the FASB opts for a fair-value-based approach: "I think if it came down to fair value for financial instruments, you would find supervisors, prudential authorities, central banks and others would not think it's reflective of high-quality financial reporting - or of the business model at use at most banks - so I think there could be some real problems."