The idea of an “economic cycle reserve” (ECR) to bolster bank balance sheets, as proposed in the Turner Review, is supported by a wide range of UK investors, auditors and preparers of accounts.
The Financial Reporting Council (FRC) has been promoting the idea of an ECR both within the UK and through the international Financial Stability Forum. Just before the Turner review was published, the Accounting Standards Board (ASB) organised a meeting of about 40 representatives of investors, accountancy firms, the banking industry and regulators to discuss counter-cyclical measures.
An ECR would be built up during the upswing of the economic cycle through an appropriation from retained profits. It would be an undistributable balance sheet reserve, limiting a bank’s ability to pay dividends and make share buybacks during the upswing and available to be released in the bad times. It is a “rainy day” provision.
The consensus view of the meeting was:
- there is support for economic cycle reserving if it is agreed between the bank and its regulator;
- provisions should not be implemented in a way that impacts the P&L of a company;
- the International Accounting Standards Board (IASB) should look at the requirements of IAS 39, particularly the relative merits of the incurred loss and expected loss models; and
- there are likely to be unforeseen circumstances affecting all the potential solutions being considered.
Ian Mackintosh, Chairman of the ASB, set out two routes to implementing “dynamic” provisions, or reserves, that would help alleviate downturns in the economy: a change in accounting requirements or a change in regulatory requirements. From an accounting standard setter’s point of view, the latter was more advisable.
Ian Wright, Director of Corporate Reporting at the FRC, explained that ECR required judgement to be applied by the management of the bank and the regulator when setting the reserve levels, and for ongoing monitoring of that initial judgement. It allowed a holistic view to be taken of a bank’s balance sheet and the amounts that should be set aside in the good times to help it survive the bad.
Among the points made by participants were:
In relation to economic cycle reserving
- The Spanish model of Dynamic Provisioning (DP) is attractive to those who suspect that banks are not as profitable as they appeared in recent years. But the prudential regulators will need to take a lead in this issue and set the levels of ECR or DP.
- The ECR should not be formula-based, it should require some judgement. It is a bridge between accounting capital and regulatory capital and may require a change in the law. It needs to be fleshed out as to the legal requirements and how it would be implemented in a group situation.
- The credit spread is a key judgement for bank balance sheets and management must ascertain and set aside the correct amount. They do not seem to have done so. When the entire market has been mispricing the credit risk, a single institution and its auditor find it difficult to contradict the market. A regulator is better placed to make this point to the market as a whole.
- If DP relies on statistical modelling then it may not be a real solution. The problem with modelling is often that the model may not best reflect the complex products being priced/provided for, nor the risk of an extreme event.
- The capacity for banks to leverage has an important impact on its provisioning and the credit risk. Regulators have permitted banks to leverage to a very high level. Pro-cyclicality cannot be countered without resolving the issue of how much banks are permitted to leverage.
In relation to the impact on the P&L
- It cannot be assumed that accounting and regulatory lessons arising from this recession can be married together. Financial statements are produced for the benefit of investors. Transparency is important to users. Measures that amount to profit smoothing or providing a pretence of cushions when none exist do not convey transparency.
- Loan provisions are an important part of a bank’s balance sheet and have a direct impact on its profit or loss. By implementing dynamic provisions through the loan provisions and thus through the P&L you build an additional judgement on the economic cycle into this most important figure. Economic cycles tend to last between seven to ten years and the average duration of a loan on a bank’s balance sheet tends to be two to three years. Trying to marry these two together to arrive at the DP figure through the P&L would be extremely complex.
In relation to the provisions of IAS39
- The IASB was supported in considering whether improvements can be made to the incurred loss model of IAS 39. In particular, it will be helpful to consider a separation between losses calculated by the incurred loss method and those on the expected loss model; the expected loss component would need to be built into the fair value concept.
- The expected loss model requires foresight and, in nature, is very close to the fair value model. It is therefore likely to have the same problems as the fair value models and attract similar criticisms.
- Regulators are most concerned about the pro-cyclicality of loss reserves. The expected loss model by itself will not allow enough capital to be built up to ensure a bank’s viability during a recession.
- Accounting currently looks at the relationship between the borrower and the lender at the transaction level. Provisioning or reserving that takes the economic cycle into account operates at a much higher level and is likely to change accounting as it currently stands.
