Proposed rules could trigger billions in losses for banks

New accounting rules proposed in March could cause billions of dollars in losses for banks.

The focus of these proposals is to require entities to record credit losses sooner, and lower hurdles have been set for triggering asset impairments.

The existing rules took heat during the financial crisis, as concerns arose over whether banks had delayed recognizing losses for too long, which allowed them to snowball and forced defaults and government bailouts.

Now, the International Accounting Standards Board (IASB) has published its recommendations, which are out for public comment until July.

After the public phase, the process will return to the accounting netherworld for further deliberation before emerging as a new rule.However, the amount of time that will take is uncertain, given the scope of the planned changes.

Tony Clifford, a partner in charge of global financial instruments for Ernst & Young, describes it as the single biggest change in accounting that banks may ever have to deal with.

The rules

The current rules employ what’s called an incurred-loss model, which requires that a credit loss event, such as a decline in fair market value, occur before a loss is recorded in financial statements. Generally, assets need to be close to defaulting before any credit losses are recognized.

These hurdles exist so that companies can’t make sweeping general provisions that could result in financial manipulation. For instance, the rules prevent companies from pumping up loss provisions in already bad quarters, which could make future results look better (also known as “big bath” accounting).

The proposed rules recommend recording impairments more promptly as credit quality deteriorates. While this may seem better on the surface, theory often falls apart in practice.

Deterioration in credit quality can depend on estimates and forecasts using the historical impact of various economic inputs, such as property values, unemployment, and credit ratings.

Recognition of movement from quarter to quarter creates more volatility in reported results as losses are triggered.

Also, it leads to a lack of consistency in judgment from bank to bank, making financial comparability between institutions more difficult.

New categories

The proposed rules require banks to examine potential losses in two different asset categories.

• Financial instruments that haven’t deteriorated since they were originally recognized, or have investment-grade characteristics.

  For these instruments, banks would estimate the potential for a credit loss within the next 12 months, and then extrapolate over the lifetime cash flows. This equates to more than the potential losses over the next 12 months, but doesn’t look more than one year into the future. A significant difference from the current rules is that potential losses are recognized even though there’s no expectation of a credit loss. Put another way, there’s always some loss provisioning on instruments from day one.

• Financial instruments where there has been a significant deterioration of credit quality since last reported.

  In these cases, banks would estimate lifetime losses by considering the impact of possible default during the life of the loan or security. Therefore, estimated losses are not weighted solely on the probability of default within the next year. If the instruments also exhibit evidence of impairment, then interest revenue is no longer recorded on the portion that’s impaired.

  The difference between the two categories seems obscure considering the increased losses that would be recorded by moving from the first to second asset bucket. With this in mind, the proposed rules provide some guidance, including that if a contractual payment is more than 30 days past due, then significant deterioration has occurred.

Drawbacks

There’s still room for judgment when estimating losses. IASB says the success of the new proposals require “faithful and effective application of the principles.”

Translation: Management needs to apply broad ideas, not seek specific clarification or look for hard and fast rules. But this has always been a major weakness of IFRS from an investor’s viewpoint.

Even assuming that management has no intention of manipulating accounting, there’s not enough guidance to expect that different management teams will produce comparable results between banks. So there are still significant problems for financial analysis and valuation.

Adding to the comparability problems, U.S. accounting rule-makers have decided to take their own path, drafting a new set of proposed rules for credit losses concurrent with the IASB. But Canadian banks follow International Financial Reporting Stanards (see “Problems with IFRS,” this page) because they tied their fates to the IASB several years ago.

The irony is that Canadian banks had a reputation of being among the safest in the world during the financial crisis.

Now they face the prospect of reporting significant credit losses and highly volatile financial results due to the whims of European lawmakers.

When accounting bodies made the case to bring IFRS to Canada six years ago, we warned of several drawbacks, including:

• greater volatility in financial results;
• decreased comparability between companies’ financial results;
• the loss of Canada’s voice in setting accounting standards, and increased exposure to the more politicized rule-making processes common to Europe and the IASB; and
• decreased comparability with the accounting standards of our largest and closest trading partner — the U.S.

All of these drawbacks are exhibited in the proposed rules. Investors will test unproven ground while wading through a mountain of dubious new financial disclosure in annual reports. And because IFRS is still new, this won’t be the last major change borne out of the financial crisis.

The lesson? It’s becoming increasingly difficult for investors to compare financial information year over year. This calls into question how useful quantitative approaches that rely on historical information are for back-testing portfolios and other investment strategies.

Pundits are predicting the additional credit losses for banks will be in the billions.

This will lead to pressure on capital ratios. The extra volatility in financial results created by the proposed rules will make it harder to raise capital in the market. Now when’s the last time a quant-based model predicted something like that?

Problems with IFRS

To facilitate consistent accounting of insurance across countries, the International Accounting Standards Board drafted IFRS in 2010. It seeks to avoid discrepancies, but doesn’t always jibe with the insurance business model.

“The proposed IFRS Phase II methodology for insurance delinks liabilities from their supporting assets,” says Garry MacNicholas, senior vice president and chief actuary, Canada Life. “The market value of assets will fluctuate as spreads move; however, liabilities will not change in the same way.” This approach is flawed.

“It introduces sizable but largely meaningless volatility into life insurance financial reporting, raising significant concerns with investors and regulators,” he says. “It also hampers the provision of long-term life insurance and annuity products. In turn, this will severely reduce insurers’ ability to make long-term investments.”

MacNicholas hopes IFRS will address these concerns. So far, he’s seen progress on: discounting connected to the backing assets; interest-rate volatility going through the balance sheet rather than through P&L; and considering the risk participation by policyholders.

—Melissa Shin, managing editor of Advisor Group

Dr. Al Rosen, FCA, FCMA, FCPA, CFE, CIP and Mark Rosen, MBA, CFA, CFE run Accountability Research Corp., providing independent equity research to investment advisors across Canada.