1 Advanced Program in Accounting and Auditing Regulation Module 23 Prof. Arnold Schilder Chairman BCBS Accounting Task Force 3 May 2006

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Advanced Program in Accounting and Advanced Program in Accounting and Auditing RegulationAuditing Regulation

Module 23Module 23

Prof. Arnold SchilderProf. Arnold Schilder

Chairman BCBS Accounting Task ForceChairman BCBS Accounting Task Force

3 May 20063 May 2006

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Agenda

1. Interaction between financial reporting and prudential reporting1. IFRS and prudential reporting2. Bridging the gap: filters, guidance, templates

2. IAS 39: supervisory response1. Impact on regulatory capital2. Loan loss allowance guidance3. Work ahead

3. Need for robust audit: recent initiatives

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Overview

1. The information that prudential supervisor needs is not always available from the financial reporting (= the published financial statements)

2. Completely separate prudential reporting is expensive and can result in internal control risks and behavioural risks

3. Therefore: use financial reporting as much as possible

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IFRS and prudential reporting

• Financial reporting is becoming more risk-sensitive IAS 39 (recognition and measurement of (innovative)

financial instruments, (collective) loan loss allowances), IAS 32 (presentation of innovative instruments), IFRS 7 (financial risk disclosures), consolidation of innovative financial structures

• The regulatory capital framework is also becoming more risk-senstivePillar 1 (IRB-approach, operational risk), Pillar 2

assessment, Pillar 3 disclosures• But…

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• … there are differences in risk perception…

Financial reporting takes a neutral view of risk; prudential reporting focuses on downside risk

Financial reporting is moving more slowly towards recognising portfolio risk and portfolio risk management

Financial reporting is moving towards a shorter time horizon; the focus is increasingly on what is now

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• … and differences in risk measurement

Financial reporting is moving towards more flexible measurement principles Increased use of fair values; also for illiquid financial

instruments IAS 39 fair value option (FASB fair value option

proposal) Financial reporting differentiates risks less explicitly than

prudential reportingRegulatory capital is computed using explicit risk

weightings

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• … and differences in presentation

Financial reporting is becoming less specific in formNo specific standard for banksNo specific reporting formats

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Bridging the gap

• Prudential filters: adjust financial reporting to (1) eliminate artificial volatility; (2) maintain level of regulatory capital

• Prudential guidance: complement financial reporting to support prudential reporting (e.g. fair value option, loan loss allowances)

• Prudential reporting templates: complement financial reporting to support prudential reporting (e.g. FINREP, COREP)

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Prudential filters

• Eliminate artificial volatility

Reverse fair value gains and losses on liabilities for banks’ own credit standing

Reverse fair value gains and losses on cash flow hedges

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Prudential filters

• Maintain level of regulatory capital

• Examples:Deduct goodwillMaintain prudential framework for: (1)

classification of debt versus equity; (2) trading book; (3) securitisations

Reallocate fair value gains and losses between Tier 1 and Tier 2 capital

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Prudential guidance

• Prudential filters not preferred route in all casesExploit strengths of financial reportingRecognise reporting burden on banks

• Apply prudential guidance where this solves the problemAccept financial reporting if subject to robust

risk management consistent with prudential norms

If not, consider prudential measures

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Prudential reporting templates

• FINREP (FINancial REPorting framework): based on IFRS

• COREP (COmmon REPorting framework): based on CRDPromote convergence of supervisory practicesPromote harmonisation of informationFacilitate exchange of informationReduce reporting burden on banks operating cross-

border

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Agenda




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Overview

1. IAS 39 has merits and drawbacks for the prudential supervisor

2. Supervisory response is necessary

3. IAS 39 is an ongoing project

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Impact on regulatory capital

• Qualitative analysis indicated need for responsePress releases (prudential filters)Prudential guidance (fair value option, loan loss

allowances)

• Quantitative analysis (CEBS) indicated need for monitoringFair value optionLoan loss allowancesHedge accounting

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CEBS impact analysis (transition)2004 2005 ∆(%)

Financial assets (HFT) 977 1,696 74

Financial assets (FVO) 58 288 394

Financial assets (AFS) 690 810 17

Loans and receivables 4,870 4,717 -3

Financial assets (HTM) 174 63 -64

Financial liabilities (HFT) 569 1,198 111

Hedging derivatives (liabilities) 1 36 2,531

In billions of euros

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Regulatory response: why?

• Prudence: forward-looking recognition of losses; critical recognition of gains

• Reliability: measurement of non-traded instruments

• Economic risk recognition: volatility; portfolio risk (management)

• Definitions: eligible capital instruments, trading book, securitised assets

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Regulatory response: what?

• Prudential filters (treated earlier)

• Prudential guidanceFair value option guidance (under

consultation)Loan loss allowance guidance (under

consultation)

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Loan loss allowance guidance (1)

• Purpose of the guidance

Highlight principle of robust loan loss allowances under financial reporting standards

Provide guidance for evaluating loan loss allowances from a prudential perspective

Highlight need to act when loan loss allowances do not satisfy prudential norms

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• Content of the guidance

Ten principles coveringSupervisory expectationsSupervisory action

Highlight differences between financial reporting framework and prudential framework

Encourage use of common inputs for credit risk assessment, financial reporting and prudential reporting

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• Implementation of the guidance

Identify when to recognise loan losses Determine how to calculate loan losses Analyse loan losses against prudential norms

Integrate data and processes to the extent possible Manage separate data and processes from point of

divergence

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• Implementation of the guidance

Process review Dialogue with external auditor Dialogue with prudential supervisor Dialogue between external auditor and

prudential supervisor

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The work ahead: short-term

1. Monitor application of fair value option on banks’ capital base and business practices

2. Monitor level of banks’ loan loss allowances under IAS 39

3. Monitor developments in fair value measurement project (including fair value hierarchy)

4. Remain open to initiatives to refine the IAS 39 hedge-accounting framework

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The work ahead: long(er)-term

1. Address fundamental issues to accommodate broader stakeholder base Conceptual framework project is first contribution

2. Key aspects for consideration include: Risk sensitivity: economic risk recognition Risk perception: forward-lookingness Risk measurement: reliability Feasibility and cost of application and enforcement

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Agenda




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Overview

1. Regulatory framework relies on audit (reliable reporting)

2. Audits must be performed, and be perceived to performed, independently and to a high quality

3. Improvements in audit have been made

4. There is room for further improvement

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Interaction with regulatory framework

• Prudential reporting (which is based on financial reporting inputs) relies on reliable information (e.g. application of financial reporting standards (fair values, loan loss allowances))

• Market discipline (including Pillar 3) relies on reliable information

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Recent initiatives in audit

• Regulatory intervention

• Introduction of oversight: PCAOB (US), EGAOB (EU)

• Revised legislation (EU 8th Directive)

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• IFAC institutional reform

• Introduction of oversight: PIOB with strong regulatory input

• New CAG with independent chair and pro-active Working Groups

• Stronger focus on public interest:• International Auditing and Assurance Standards

Board (IAASB)• International Accounting Education Standards

Board (IAESB)• International Ethics Standards Board for

Accountants (IESBA)

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• IFAC technical reform

• Revised Code of Ethics• Clarity Project• Review of standards• Explicit identification of public interest entities• Focus on conduct, including corporate

conduct

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EU 8th Directive

• Formal adoption foreseen in 2006; transposition into national law within two years

1. Independent public oversight2. Auditor independence (audit vs non-audit services)3. Mandatory rotation (key audit partner; public interest

entities; every 7 years at the latest)4. Requirement for listed companies to set up audit

committee or equivalent body5. Limited liability (EC invited to issue report before end

2006)

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The way ahead

• BCBS applauds efforts so far

• Areas for ongoing improvement• PIOB focus: Balanced composition of IFAC boards,

public accountability, quality of audits worldwide• Technical improvements: Clarity Project, ethics,

review of IAPS 1006 (auditing the financial statements of banks)

• Specific focus on interactive tools such as XBRL (financial and prudential reporting)

• Continuing dialogue between regulators and audit profession

• Continuing dialogue among regulators

Documents

1 Advanced Program in Accounting and Auditing Regulation Module 23 Prof. Arnold Schilder Chairman BCBS Accounting Task Force 3 May 2006