13 August 2012

BIS: Speech by Vítor Constâncio on accounting, financial reporting and corporate governance for central banks

BIS published the opening remarks by Vítor Constâncio, Vice-President of the ECB, at the third conference on accounting, financial reporting and corporate governance for central banks held in Frankfurt on 4 June, 2012.

The aim of the conference was to compare notes on recent accounting developments from a central bank perspective and in that way to learn from each other’s experiences.

The conference was structured around a number of presentations on three interrelated parts, each of which was dealt with in a number of presentations from different perspectives.

The first part dealt with the impact of international accounting developments on central banking, with particular focus on the interaction between accounting and financial stability. In Mr Constâncio's remarks he focused on the tension between these two fields of expertise.

From the perspective of financial stability considerations, Mr Constâncio recalled two specific examples where the current accounting paradigm may be detrimental: First, the extent to which the application of fair value accounting may provide adverse incentives regarding management and investment decisions. The crisis has largely confirmed the scepticism that fair value is not the most relevant measurement for all asset portfolios at every moment. That would not be the case if all financial markets would obey to the canons of perfect competition, would process information with full efficiency and would not be subject to overshooting, herd behaviour and price misalignments during significant periods of time. As this does not correspond to the real world, full fair value tends to create what has been dubbed as “artificial volatility” in a company’s earnings, particularly in the case of financial institutions. When profits are artificially inflated, this may lead to higher dividends and bonuses based on the recognition of unrealised gains. The undesirable side effect of such payments would be an effective depletion of capital; a capital cushion that might be needed at a later stage when the markets correct. In some cases, fair value accounting may provide information that is in Mr Constâncio's view outright wrong even for investors.

The second example where accounting seems to have an impact on market dynamics and cyclicality within the financial system is the provisioning or impairment methodology. The main criticism of the “incurred loss” model that is currently in place was that it did not reflect the need for earlier recognition of loan losses. Under this model, the bank would usually start to provide for the related credit losses only once those losses actually materialised.

The second part of this conference dealt with the sensitive issue of the financial strength of central banks.

This issue has become more relevant over the last years as, due to non-standard operations, balance sheet risks - and in particular credit risk - have increased for a number of central banks. A lot has been written by central bank experts in the past decade on central bank independence and the link with the central bank’s financial strength, sometimes with conflicting views. A number of studies have argued that financial weakness could impair the central bank’s pursuit of price stability. Other studies have suggested that central banks can successfully operate with negative equity.

The ECB takes this matter very seriously, especially when reviewing any legislative proposals in the EU which affect individual central banks. The ECB, as a relatively new institution, has been viewed as having a strong degree of independence based on the relevant EU legislation backing the establishment. In particular, the principle of central bank independence is an essential element of the ESCB Statute.

The third part of this conference was devoted to financial reporting in central banks.

It is evident that in the context of the financial crisis the operations and balance sheets of central banks are in the public spotlight. The effective communication of the nature and the outcome of these operations is of profound importance. This is true mainly for two reasons.

The first reason is that the central bank is accountable to society for the use of resources entrusted to it. However, the financial performance of a central bank is not necessarily a good indicator of an effective pursuit of policy goals. Excess or little accounting returns as well as balance sheet risks can be associated with the central bank policy operations.

However, the real benefit or loss for the society does not, in Constâncio's opinion, come from these returns. It comes from the effective or ineffective implementation of policy objectives. And this very fact should be properly highlighted and communicated.

The second reason why communication is important is linked to the effectiveness of the policy operations. An operation is less likely to be successful if it is not combined with an appropriate communication that allows the stakeholders to understand the nature, the objective and the outcome of these operations. Financial reporting serves as an important communication channel here.

Full speech

© BIS - Bank for International Settlements