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)| false Enria, Andrea, Lorenzo Cappiello, Frank Dierick, Sergio Grittini, Andrew Haralambous, Angela Maddaloni, Philippe A.M. Molitor, Fatima Pires, and Paolo Poloni, 2004, “ Fair Value Accounting and Financial Stability,” ECB Occasional Paper Series No. 13 ( Frankfurt: European Central Bank).
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The authors are thankful to Kenneth Sullivan, and participants at the 10th Accountants Forum of the IMF, as well as a number of staff of the IMF, for their comments and suggestions. We are also indebted to Yoon Sook Kim and Xiaobo Shao for their research and technical support.
Non-derivative financial assets with fixed or determinable payments and fixed maturity that an entity has the intention and ability to hold to maturity.
Namely, when they are risk-managed on a FV basis, though differences remain between FAS159 and IAS39.
Nevertheless, differences are disappearing given the international convergence to IFRS currently underway, led jointly by the International Accounting Standards Board (IASB) and the U.S. Financial Accounting Standards Board (FASB), which is aimed to achieve a single set of high-quality international accounting standards.
This language is U.S. GAAP-specific and not IFRS, but it is used extensively in the banking industry and in financial statements of IFRS users as well.
IFRS do not explicitly mention some risk factors (e.g., counterparty credit risk, liquidity risk), which may have added confusion to financial statement preparers during the 2007–08 turmoil. An International Accounting Standards Board Expert Advisory Group is currently working on this and other FV issues. The U.S. Financial Accounting Standards Board is reevaluating some disclosure requirements (e.g., credit derivatives) and has issued new standards (e.g., FAS 161 on derivatives and hedging). Both Boards are working jointly on FV issues and examining requirements for off-balance sheet entities, as well.
White papers prepared by the six largest international audit firms and other audit firms summarize guidance on what constitutes an active market, FV measurement in illiquid markets, and forced sales, CAQ (2007) and GPPC (2007). Further, on September 30, 2008, the U.S. SEC jointly with the U.S. FASB issued new guidance clarifying the use of FVA under the current environment and, on October 10, 2008, the U.S. FASB staff issued Staff Position No. 157-3 providing guidance on how to determine the FV of a financial asset when the market for that asset is not active.
IFRS 7, “Financial Instruments: Disclosures,” became effective on January 1, 2007.
For those financial assets measured at amortized cost, the entity must also disclose the FV in the notes to the statements.
Including audit-related programs.
The FSF recommends disclosures about price verification processes to enhance governance and controls over valuations and related disclosures. Disclosures regarding risk management governance structures and controls would also be welcome.
Examples are the U.S. S.E.C. letters of March 2007 and March 2008 to major financial institutions outlining the nature of recommended disclosures and the most current letter of September 16, 2008.
“Leading-Practice Disclosures for Selected Exposures,” April 11, 2008. Twenty large, internationally oriented financial firms were surveyed (15 banks and five securities firms) as of end-2007.
Canada has postponed adoption of the full International Financial Reporting Standards until 2011.
Barth (2004) argues that mixed-attributes models impair the relevance and reliability of financial statements and that this constitutes one of the primary reasons behind hedge accounting. IAS 39 was aimed to alleviate mismatches in assets and liabilities valuations due to the mixed-attributes model and the complexities of hedge accounting.
It should be noted that procyclicality of accounting and reporting standards existed prior to the recent attention to FVA. It has long been recognized that as the business cycle and market sentiment change, so too will valuations of assets and liabilities.
IFRS and U.S. GAAP accounting standards—and FVA is no exception—are applicable to reporting entities irrespective of their size or systemic importance.
One intention of the FVO in both accounting frameworks is to enable entities to reduce accounting mismatches by applying FV on matching assets and liabilities.
Bank supervisors use prudential filters as a tool to adjust changes in the (accounting) equity of a bank due to the application of the accounting framework, so that the quality of regulatory capital may be properly assessed. For example, when the gains that result from a deterioration in a bank’s own creditworthiness (fair valued liability) are included in a bank’s prudential own funds, they must be “filtered out” by the supervisor in order to determine the true amount of regulatory own funds..
In principle, valuations are thus better aligned with the prevailing mark-to-model techniques used in risk management.
The U.S. Financial Accounting Standards Board has a project under way to address provisioning and related credit risk disclosures.
In mid-October 2008, the IASB amended IAS39 to allow some reclassifications of financial instruments held for trading or AFS to the HTM category, meeting certain criteria, with the desire to reduce differences between IFRSs and US GAAP.
See Enria et al. (2004), who examine the impact of several one-off shocks on the balance-sheet of a representative European bank under alternative accounting frameworks.
The filing period was chosen to be December 2006 in order to obtain balance sheets that are relatively recent, while at the same time do not reflect too closely banks’ balance sheet structure in the run-up or fall-out of the 2007-08 US sub-prime meltdown.
For simulation purposes, all banks were assumed to be newly established, so that all balance sheet items are at FV at the start of the simulations. Thus, the shocks applied to the baseline reflect only the pure impact of the shocks, and not a combination of the imposed shock plus any initial deviations from fair value.
IAS 39 prevents the valuation of demand deposits at a value less than face value, even if a significant portion of these display economic characteristics of a term deposit. Consequently, deposits remain at face value in the exercise.
Despite being a central element in the 2007–08 turmoil, an explicit breakdown of credit derivative exposures was unavailable in the 2006 reports. Some mortgage backed securities were included in the debt securities category.
Strictly speaking, PDt is the conditional probability of default at time t. That is, the probability that, conditional on not having defaulted before, a loan defaults on period t.
It should be noted that the Quantitative Impact Study 5 (QIS-5) estimated the PD for a group of G-10 (ex-US) banks’ retail mortgage portfolio at 1.17 percent, very close to the estimate of 1.18 percent for the trend period used here.
Although this may be a less realistic assumption than allowing LGDs to evolve through the cycle, the qualitative results of the simulations would not be altered.
The initial price of the representative stock held by banks was normalized to the value of the S&P 500 Index at end-2006, which closed at 1,418 on December 29th, 2006.
To estimate the PDs during the 2007–08 U.S. housing crisis, it was assumed that 100 percent of foreclosures and 70 percent of delinquencies beyond 90 days end up in default. These percentages are then combined with the respective PDs to yield an overall estimated PD of 5.29 percent for all mortgages. See UBS (2007); data source: Merrill Lynch, April 2008.
The rationale behind this characterization of distressed markets follows Altman et. al (2005) in that during times of distress, the demand for securities declines hence reducing both the market price and the recovery rate (i.e., the inverse of LGD) of securities. See Acharya et al. (2007), Altman et al. (2005), and Bruche and González-Aguado (2008) for papers discussing the link between distressed markets and increases in LGD rates.
The results are presented in terms of the evolution of banks’ normalized equity through the cycle—that is, at each point in the cycle, banks’ equity is divided by their initial level of equity (i.e., at end-2006). All figures for this section are presented at the end.
Note however that this result reflects only one element of countercyclical forces, as “other liabilities” represents about 50 percent of the balance sheet and can potentially introduce additional countercyclicality.
Chapter 4 of IMF (2008) examines procyclicality of leverage ratios of U.S. investment banks, finding their extreme variation across the cycle. Note this is consistent with the scenario conducted later in this paper where funding spreads vary through the cycle, producing the same procyclicality found in IMF (2008).
See Guerrera and White (July 8, 2008). Additionally, Barth et al (2008) suggest that these counterintuitive effects are attributable primarily to incomplete recognition of contemporaneous changes in asset values.
Some portion of the lower equity position in European banks may stem from differences in IFRS versus U.S. GAAP accounting treatments (cf. Citi 2008, Financial Times, 2008).
Note, however, that retail-oriented European banks also have a larger fraction of debt securities and financial liabilities than the larger European banks.
In effect, valuing these instruments at amortized cost would produce comparable results to being classified as HTM.
Although this simulation is subject to the Lucas critique in that bank behavior is assumed not to change in response to policy adjustments, it provides some insights into the interaction between FVA and interest rates.
Interestingly, the addition of changes in the yield curve counteracts the effect of the evolution of PDs. The drop in the yield curve in the downturn results in higher valuations and thus counterbalances the downward effect of the PDs, while the positive effect on valuations stemming from lower PDs is counterbalanced by a higher yield curve in the upturn.
This simulation abstracts from the effect of revaluing interest rate swaps. Unfortunately, it was not possible to obtain a sufficiently complete and consistent dataset on these instruments to include them in the simulation. Nevertheless, preliminary results using available data on interest rate swaps showed similar qualitative results.
Although the weaknesses are related more to issues of OBSEs, consolidation, and derecognition, than to FV.
Forward-looking provisioning denotes provisions based on the likelihood of default over the lifetime of the loan, reflecting any changes in the probability of default (after taking into account recovery rates). Dynamic (or statistical) provisioning can be considered an extension of forward-looking provisions with reliance on historical data on losses for provisioning calculations. Conceptually, dynamic provisioning would entail that during the up-side of the cycle, specific provisions are low and the statistical provision builds up generating a fund; during the downturn, the growth in specific provisions can be met using the statistical fund instead of the profit and loss account. Enria al (2004) and Bank of Spain (www.bde.es).
Basel Committee on Banking Supervision (2006b) and IAS 39.
FASB’s XRBL project for financial institutions would provide data on-line in about three years, as discussed in the IMF April 2008 edition of the Global Financial Stability Report (IMF 2008b).
This would be separate from U.S. SEC 10-Q filings.