Breakthrough seen in key accounting wrangle
Latest paper closes gap between banking regulators and accounting rule-makers on the vexed fair value option problem. By David Keefe
Early signs are that a breakthrough has been achieved in the arcane fair value option problem in new international accounting rules that's threatened a split between global accounting rule-makers and banking regulators.
Banking regulators gave a fair wind of approval in initial reactions to a proposed solution that tries to calm their fears that the option might be used by weak banks to paint a false picture in their accounts of their financial affairs. New wording aims at limiting wrongful use without choking off the legitimate exercise of the option by banks, insurers and investment firms.
Under the new proposal, which was devised by staff with the International Accounting Standards Board (IASB), firms taking the option would have to make clear their reasons for using it and show how it fits into their asset management liability policies. The object is to elicit a firm's purpose in choosing the option, thereby restricting the room for manoeuvre for a bank with dubious motives.
The requirement is a response to the worries of banking regulators, including the Basel Committee on Banking Supervision and the European Central Bank, that an earlier attempt to resolve the issue failed to stress the need for a strong risk management context within which the option might be exercised.
The abstruse dispute has dragged on for months. It pits the interest of banking regulators in limiting the scope for troubled banks to mask their problems against the freedom of both financial and non-financial firms to use the option to avoid distorting their accounts.
On a broader level, it threatens another fissure between the demands of financial regulation and the fair value principles behind the new international accounting rules known as International Financial Reporting Standards (IFRS) that came into effect in many countries on January 1. Accounting rule-makers and bank regulators have accused each other of not properly understanding the other's business.
A failure to resolve the issue would result in regulators having to create more so-called prudential filters that would disregard the effects of IFRS for the purposes of assessing how much capital banks, insurers and investment firms need as a safeguard to absorb financial loss from the risks they face. Prudential filters are often technically necessary. But regulators fear that too many, particularly in relation to basic accounting practices, could undermine the useful aim of keeping accounting and regulatory definitions in line as far as possible.
The as yet unresolved arguments about the fair value option were cited by the European Commission, the executive arm of the European Union, as one of the reasons for its temporary adoption of a diluted form of the notorious IAS 39 rule, of which the option is part, for valuing financial assets and liabilities under IFRS. The Commission's version prevents firms from using the option in respect of their liabilities. Critics argue that the EU's partial adoption of IAS 39 undermines the ultimate aim of IFRS, after convergence with US GAAP (Generally Accepted Accounting Principles), of achieving a single set of high-standard global accounting rules.
In early February the EU's top financial regulator, internal market commissioner Charlie McCreevy, called in "firm terms" for urgent action from bankers and the IASB, the London-based accounting rule-maker that developed IFRS, to settle the fair value option issue. In the same speech, McCreevy reiterated his desire to see greater democratic governance and political accountability of such bodies as the IASB (see page 17).
Favourable response
But the IASB's revised attempt at a solution*, which appeared a few days after McCreevy's remarks, attracted a favourable initial response from Arnold Schilder, the Dutch central banker who heads the Basel Committee's accounting task force.
"All in all, this (the IASB's latest paper) is much better - it's a strong improvement on the previous one and I'm much happier with it," Schilder says.
But he stresses this is his own informal and immediate opinion of the redraft. A formal judgment is up to the task force, which develops regulatory policy on the accounting aspects of bank capital adequacy and safety, and ultimately the Basel Committee. Nevertheless, Schilder says the task force is preparing a response that he hopes "would come to a positive conclusion".
It's harder to gauge the reaction of the more disparate insurance regulatory community and the equally disparate insurance industry which had strong objections to the earlier paper. The insurance industry is essentially against any restriction on the use of the fair value option.
But one insurance regulatory source with international responsibilities says on first impressions the proposed solution is one that could work for insurers and their supervisors.
As GRR went to press, the International Association of Insurance Supervisors (IAIS), which represents insurance regulators in more than 120 countries, was seeking views on the paper from members.
Similarly, the Comité Européen des Assurances (CEA), the Paris-based federation of European national insurance industry trade bodies, was asking for its members' reactions.
The CEA has previously said 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.
Meanwhile, IASB staff are keeping their fingers crossed that a one-day meeting in London on March 16, at which all interested parties can debate the issues, won't throw up further objections that could slow progress toward a solution. Questions of detail relating to terminology and definitions still remain.
"We're not planning a coronation ceremony yet," says one IASB official.
The IASB is anxious not to have to issue yet another exposure draft, or formal consultation document, on the subject - something that could delay agreement for up to a year.
Under IAS 39, financial instruments such as derivative contracts and bonds and shares held for trading must be measured at fair value. 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.
But the IASB provided firms with an option - the fair value option - that allows them to nominate, once and for all, 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 IASB responded to these fears 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.
The IASB made a further response in December with a paper promoting 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.
Summarising some 30 comments received on the paper, IASB staff said a bank regulator and bank/insurance supervisor were worried that the approach wasn't sufficiently restrictive. A securities regulator, however, broadly supported the direction of the approach.
The Basel Committee's Schilder said separately that the paper needed to put emphasis on sound risk management principles as the context for using the option.
The three banks responding indicated that the proposals would address most situations in which banks might want to use the option.
But it was clear that insurance firms saw the new proposal as too restrictive. All eleven of the insurers and insurer representative bodies responding said it would prevent insurance companies from using the option in several areas where they would regard its use as appropriate.
Examples cited included assets backing general insurance liabilities and assets backing other non-linked, non-participating liabilities.
"Narrative description"
The IASB's February redraft rewords a key condition for using the option - that it would eliminate a mismatch that would otherwise arise from measuring items on different bases. In the new wording the principal is basically unchanged, but it makes clear that the condition applies to measurement mismatches and mismatches in the recognition of gains and losses.
The redraft would require users of the fair value option to give a "narrative description" of the circumstances that would otherwise arise if the option wasn't adopted.
To help insurers, the second condition - that the nature of the firm's activities is such that using the option results in more useful information - is narrowed and examples have been redrafted to cater for insurer needs. There is now a requirement with the second condition to describe how designation through profit or loss is consistent with a firm's documented risk management or investment strategy.
Banking regulatory sources say they're pleased the new draft explicitly links risk management to the use of the option. It also recognises more explicitly the need of prudential supervisors to understand why a regulated firm has chosen to apply the fair value option.
And they note that the December paper's third condition for using the option - that it simplifies the accounting that would otherwise be required - has been narrowed to limit it to only instruments containing one or more embedded derivatives. The new draft explains when this condition will, or will not, be met.
The February paper also requires disclosure of credit risk information on loans and receivables for which the option is used, and of any related credit derivatives or similar contracts. This is intended to compensate for the loss of traditional accounting information, under the amortised cost model, about loan loss provisions and credit risk.
The disparate nature of insurance regulation around the world means there's less likely to be a single supervisory view of the IASB paper than the powerful Basel Committee can convey on behalf of banking regulators.
The IAIS, whose secretariat, like the Basel Committee's, is hosted at the headquarters of the Bank for International Settlements in Basel, Switzerland, said in its response to last April's exposure draft on the option that its members' attitudes fell into two categories.
Insurance supervisors in jurisdictions where fair value accounting principles are applied were concerned that the IASB's proposed restrictions would generate mismatches on assets and liabilities that didn't exist previously - a fear shared by many insurers.
Supervisors in jurisdictions where measurement of liabilities at cost was required were worried that the scope of the option remained too wide.
The insurance regulatory source says the new paper could open the way to meeting both concerns.
*Amendments to IAS 39: The Fair Value Option - Preliminary Second Draft of a Possible New Approach - is available with the observer notes for the IASB's February meeting on www.iasb.org.
