Paper seeks to allay regulator fears over fair value option
LONDON, February 4 - Global accounting rule-makers are thought likely to try to allay banking regulator fears about abuse of the so-called fair value option in new accounting rules by proposing that firms using the option give clear reasons for doing so.
Accounting industry sources believe the idea will be contained in a redrafted paper on the fair value option that staff with the International Accounting Standards Board (IASB), the London-based accounting standards setter, have virtually completed.
The paper will suggest that firms using the option state clearly why they are using it and how it fits into their asset-liability management policy. It's hoped that this will calm worries among banking regulators that a previous draft of the paper in December, which outlines a "principles-based" solution to the problem, lacks a sound risk management perspective.
IASB sources declined to comment on the contents of paper. But they said the Board will publish the document ahead of its February 14-18 monthly meeting. At that meeting the Board, which comprises 14 leading international accounting experts, is expected to give the go-ahead to further discussion of the new paper. March 16 has been pencilled in as the date for a London meeting on the problem that will be open to all interested parties, including accountants, firms, trade bodies, auditors, the media and regulators.
The IASB sources say they want to avoid issuing another exposure draft, or formal consultation document, on the topic, a process that would delay a solution by another year. They noted that Europe's top financial regulator, European Union internal markets commissioner Charlie McCreevy, highlighted earlier this week the need for urgent action on the fair value option.
The new paper, which is a further refinement of a "preliminary first draft of a possible new approach" put forward in December, will also seek to meet the demands of those, strongly represented in the insurance industry, who don't want the terms of the fair value option changed at all.
The option is a part of the notorious IAS 39 rule for valuing financial assets and liabilities in a firm's accounts under the International Financial Reporting Standards (IFRS), the IASB-developed rules that came into effect in many countries on January 1, including the 25 EU member states.
McCreevy said he had called in "firm terms" on the IASB, the European Central Bank and banking regulators to settle the wrangle over the fair value option as a "matter of great urgency".
According to the text of his speech, he told the economic affairs committee of the European Parliament that he met IASB chairman David Tweedie in late January and had "impressed on him the need to move quickly and in cooperation with all those concerned".
Under IAS 39, financial instruments such as derivative contracts and bonds and shares held for trading must be measured at fair value, that is at current or market prices, rather than at original cost. Items that are less easy to value at current prices, such as loans and receivables, as well as long-term investments - bonds held to maturity, for instance - are measured at amortised cost, which is related to the accrual of interest.
But the IASB provided firms with an option - the fair value option - that allows them to nominate any financial item for fair value measurement. This is to avoid the distortions that could be caused by having economically matched assets and liabilities measured on different bases.
However, banking regulators fear that weak banks could use the option to under value their liabilities, for instance, and thereby possibly threaten financial stability. The European Central Bank and the Basel Committee on Banking Supervision, the body of senior banking supervisors from the leading economies that in effect regulates international banking, have been perhaps the most vocal about their concerns. The Basel Committee is the architect of the Basel II upgrade of international capital rules for bank safety.
The IASB responded in April last year with a `rules-based' exposure draft that proposed restricting the use of the option to five detailed categories, essentially those where markets existed to provide pricing benchmarks, to meet regulator concerns about the difficulty of otherwise establishing fair value.
However, the exposure draft was overwhelmingly rejected by auditors, accounting bodies and firms, both financial and non-financial. Only regulators seemed to approve.
Meanwhile, the European Commission, the EU's executive arm that initiates financial regulation, temporarily adopted a watered-down version of IAS 39. This was in response to fears among some banks, particularly in France, that the IFRS fair value provisions for derivatives could distort their accounts. The diluted IAS 39 `carves out' certain hedge accounting provisions and blocks the use of the fair value option for liabilities. Critics say the carve outs undermine the ultimate goal of achieving a single set of global accounting rules.
The IASB's December paper promotes a principles-based approach aimed at getting firms using the fair value option to observe the spirit of its intent, which is to prevent accounting distortions and not to provide a means of creating an accounting smokescreen to deceive regulators and investors.
The IASB has summarised comments on the December paper, without naming the sources of the 30 responses received. It says three regulators responded - a bank regulator, a bank/insurance supervisor and a securities regulator.
The bank and bank/insurance supervisors reiterated their fears that the latest approach is not sufficiently restrictive. The securities regulator broadly supported the direction of the new approach.
Banking industry sources believe the Basel Committee did not respond in writing to the paper. But Netherlands central banker Arnold Schilder, who heads the Committee's accounting task force, told Global Risk Regulator in January that he'd like to see a more restrictive approach with more emphasis on sound risk management principles (see GRR newsletter, January 2005).
Of the three banks responding, one specifically said the proposal would address most situations in which banks want to use the fair value option.
But the IASB said it's clear that insurers see the new proposal as too restrictive. All eleven of the insurers and insurer representative bodies said insurers would be unable to use the fair value option in several areas where they would regard its use as appropriate.
The Comité Européen des Assurances (CEA), the Paris-based European federation of national insurance trade bodies, says it wants the unlimited fair value option retained. The CEA also suggests that banking regulators' fears should be addressed though general accounting standards, rather than through specific supervisory tools such as restricting the use of the fair value option.
The argument over the fair value option is one of a number of points of friction that have developed between fair value accounting rule-makers and banking regulators in recent months.
Supervisors support the principle of fair value as a way of tracking quantitative changes in the financial risks faced by banks, insurers and investment firms.
But regulators, including US Federal Reserve Board governor Susan Schmidt Bies and Bank of England deputy governor Andrew Large, have recently warned of the impact fair value could have on the measurement of regulatory capital - the capital that supervisors require banks to hold as a buffer to absorb losses from the risks they face.
Supervisors at both national and international level have created a number of so-called prudential filters, policy statements aimed at preventing the use of IFRS leading to unintended increases or decreases in regulatory capital. Many of the filters are technical clarifications and uncontroversial. But the Basel Committee's Schilder has warned that increasing use of prudential filters could create the false perception that banking supervisors don't have full confidence in IFRS information.
Schilder has also said that accounting rule-makers need to understand better the business of banking and be more aware of the financial stability implications of their proposals.
The IASB, which is overseen by the Trustees of the International Accounting Standards Committee, declines to comment on these criticisms. But accounting experts say the rule-makers would probably counter by saying that regulators need better to understand the role of standard setting. The essential point regulators need to grasp, particularly in the context of the fair value option, is that accounting entries don't create risk, say the experts. It's a firm's activities that create risk and how those activities are accounted for won't change the risk. Banking regulators sometimes confuse the two concepts, say the accounting experts.
Meanwhile, the European Commission's McCreevy reiterated in his remarks this week his desire to see greater democratic governance and political accountability of such bodies as the IASB and the proposed International Auditing and Assurance Standards Board. McCreevy, formerly Ireland's finance minister and an accountant by profession, was appointed to his Brussels-based job in November in succession to Frits Bolkestein.
"The governance, financing, participation in and the accountability of international standard setters, in particular the International Accounting Standards Board, is becoming the subject of a heated public debate," McCreevy noted. He plans to look at existing arrangements "to see what can be done better".
Again, the IASB wouldn't comment, regarding a response as a matter for its Trustees. But accounting experts say rule-makers believe their standard setting process takes place "in the sunlight" for all to see. They fear that politicians often prefer, and McCreevy's urgings on the fair value option could fall into this category, a bogus democracy in which "they (the politicians) cook up solutions to accounting problems in hole-in-corner talks in smoke-filled rooms with special interest groups," says one expert.
"How many regulators, if any, are likely to turn up for the (tentatively scheduled) March-16 London meeting on the fair value option?" the expert asks.
However, McCreevy exonerated the Basel Committee from his strictures.
"It has been asked why we place reliance on what (in the case of the Basel Committee) is seen by some as an unaccountable, undemocratic body," he said.
But he said the Basel II rules would come into effect via EU laws - the Capital Requirements Directive - under the oversight of the EU parliament and national ministers.
"We feel that using the Basel Committee work as a basis is reasonable because of the extraordinary volume of consultation and discussion that has taken place with the industry and other interested parties over the past five years."
(For the IASB's summary of responses to its December paper see Observer Notes for the IASB January meeting at www.iasb.org; for the text of McCreevy's remarks see his "Governance and Accountability in Financial Services" speech at: http://europa.eu.int/comm/commission_barroso/mccreevy/speeches/index_en.htm; for the CEA's views see: www.cea.assur.org)
David Keefe (dkeefe@globalriskregulator.com)
