16 January 2013

IASB Submission to UK Parliamentary Commission on Banking Standards

The IASB responded to following questions:

• What was the role of accounting standards and reliance on fair value principles in the banking crisis? What does a ‘true and fair view’ really represent to the market?
• What are your views on the current incurred-loss impairment model and its role in the banking crisis? Do you consider that proposals to move to an expected-loss model will address criticisms of the current accounting rules?
• What is the best method of accounting for profits and losses in trading instruments? Are there any alternatives to mark-to-market or mark-to-model that might better represent a ‘true and fair view’?
• Do we need a separate accounting regime for banks? If so, what should it look like?
• Are there any interim measures (such as mandatory disclosure) which could be introduced in the meantime?

In response to the question, "What was the role of accounting standards and reliance on fair value principles in the banking crisis? What does a ‘true and fair view’ really represent to the market?", the IASB submitted:

Accounting standards played a very limited part in the onset of the banking crisis. Although some assert that current accounting standards allowed banks to paint too rosy a picture of their true financial condition, there is very little evidence to support this assertion. Indeed, the financial statements of the banks prior to the crisis clearly showed that most banks were extremely leveraged and in a very perilous condition. The balance sheets of many banks were supported by 2% of tangible capital or even less, a degree of leverage which was unprecedented in economic history and clearly visible in financial statements. In retrospect, it is remarkable that market participants failed to pick up the very clear signals of excessive leverage in financial statements. One of the reasons why this did not happen was that many market participants were focussed on the so-called Basel capital ratios. This regulatory measurement method allowed the banks to calculate their capital ratios on the basis of risk weighted assets. It is well documented how, before the crisis, the Basel capital ratios had been gamed to increase leverage by exploitation of the risk weights. Banks with a seemingly sound Tier-1 ratio of 10 per cent could in fact be leveraged 40 or 50 times. The Basel ratios had been abused as a scheme for hiding the excessive and very dangerous leverage which market participants could and should have observed in the financial statements of the banking industry.

As for reliance on fair value principles, it is not the case, as some have claimed, that the IASB is seeking a full fair value model for financial instruments. Both the existing standard IAS 39 'Financial Instruments: Recognition and Measurement' and as well as its replacement IFRS 9 'Financial Instruments' provide for a mixed attribute model. While fair value is an appropriate measurement attribute for financial instruments that are traded, in IFRS 9 financial instruments that have basic loan features and that are managed on a contractual yield basis are measured at amortised cost. For such instruments, amortised cost is deemed to provide more relevant information. It is the case that the majority of banks’ financial assets are still valued on an amortised cost basis rather than fair value and that many of the assets that have been written-down have been those held at amortised cost. For this reason, most academic evidence available shows that the claim that fair value accounting exacerbated the financial crisis appears to be largely unfounded.

In part, fair value accounting actually helped to reveal the crisis, in particular through requiring the banks to report losses earlier than under any other accounting basis, as was demonstrated by the recent write-downs of Greek sovereign debt. This had the benefit of focusing attention much earlier on the banks’ business models and led to remedial action, such as capital raising, much sooner than otherwise would have been the case.

In sum, the IASB does not support the notion that accounting standards led to a systemic bias to overly favourable financial statements in the banking industry. Clear signals that the banking industry was extremely leveraged were simply not picked up. However, we do acknowledge that the incurred loss model for the impairment of assets was in need of improvement. Indeed, the IASB is currently in the process of replacing the incurred loss model by an expected loss model.

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Panel on Tax, Audit and Accounting

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