Trading and Banking Accounting

8/7/2019 Trading and Banking Accounting

http://slidepdf.com/reader/full/trading-and-banking-accounting 1/12

Views from the banking industry

Philippe Bordenave, CFO BNP Paribas Group

08 May 2009



2

Objective of financial reporting

• To help investors estimate the value of an entity

• The management of an entity works for shareholders and makes

decisions in order to increase the value of the company.

• Value of a company ≠ values of its assets – values of its liabilities

• When an investor purchases an entity (or its shares) he bases the

decision on his forecast of the entity’s long term capacity to generate

profit.

• DCF Model, Discounted dividend model, Synergies…

• PnL approach more usefull to investors than balance sheet

approach



3

Objective of financial reporting

• Financial reporting should help an investor assess this long term

beneficiary capacity.

• Depending on its use and the way it is combined with other

assets and liabilities, an asset can produce benefits in different

ways.

• Because an item can be used in different ways, financial

reporting must recognise and adapt to different business models.



4

An asset may have a different value depending onthe entity holding it

Take the example of a truck and its use in different businesses :

• Truck dealers will buy trucks from a producer and sell them to endusers.

• The current value of the trucks it owns is of major importance as the

purpose of its business is to buy and sell trucks. Therefore, the entity

generates profit based on changes in fair market values for trucks.

• Delivery companies will use their trucks in the long term to

generate profit by delivering goods.

• Reflecting the fair value changes of the trucks in the financial

statements would distort the representation of the company’s

performance.

• The fair representation is amortized cost in this case.



5

An asset may have a different value depending onthe entity holding it

Another interesting example involves real estate :

• If a firm predominantly uses its real estate assets for rent, it does not

make sense to present all of its assets according to their current

market values even if the entity may periodically sell some of them.

• Measuring the assets at fair value would mislead investors with regards to

the performance of the company.

• But, fair market value is key to accurately and fully reflecting the

position of a real estate developers’ business.

These two examples highlight the importance of considering the

business model of an entity in the financial reporting framework.



6

Financial Business Models

• Financial activity also encompasses very different business

models.

• Trading activity : actively buying and selling financial instruments as

one would do with trucks or buildings.

• Implies high turnover and active hedging/arbitraging.

• Banking activity : lending and borrowing money, holding and issuing

securities, and gathering deposits in order to derive earnings from the

cash flows that they generate

• It may imply selling assets occasionally, but not with significant turnover.

• Not only registered banks pursue financial activities but alsobroker/dealers, insurance companies, funds, even industrial

companies through their treasury department, …



7

Trading Book = fair market value

• Actively buying and selling is only possible in an efficient, liquid financial

market.

• If the underlying market /instrument is not liquid, activity should not be

recognized as trading.

• What does liquidity mean ?

• For a cash instrument it means : the ability to sell rapidly

• For a derivative instrument it means : the ability to hedge rapidly and perfectly

=> Liquidity = ability to rapidly close all market risks associated with a portfolio

• The three level hierarchy makes sense

• Level 3 is necessary for instruments that subsequently become illiquid.

• For example, a vanilla option written at the money and deeply in the money at

the measurement date.



8

Banking Book = fair value in use

Amortized costLiabilities

Lower of cost or value in useEquity assets

Amortized cost, with necessary impairmentsFixed income assets

Measurement basisCategory of financial

instrument

• Managing assets and liabilities in the long term for the cash flowsthey generate

• Measurement should reflect the cash flows the entity expects toreceive or pay through continuing use.

• The fair value of the banking book should only be disclosed inthe notes to the financial statements as complementary

information.



9

How to differentiate between the two Books

• There is a very clear difference between the two activities of abank.

• They follow different management practices and different prudentialrules.

• They are easily identifiable by management and auditors.

• The trading book should be defined by exception stating that,unless the trading activity and the market’s actual liquidity areevidenced, a financial instrument should be classified in thebanking book.

• In the recent past too many activities were deemed as« trading », inflating mark to market « gains » on assets whichwere in fact not saleable…



10

Derivative instruments

• Trading book :

• Derivative instruments that are managed under a trading business

model and that are traded on an active market should be measuredat fair market value.

• Banking book :

• Fair value in use for derivative instruments is a complex issue.

• We believe that it is a field that deserves being explored by

accounting research.

• However it has never been done because of the simplistic ideology

that all derivatives should be measured at fair value.



11

Derivative instruments

• Here we provide an example of a possible alternative

measurement basis for derivative instruments held in a banking

book :

• Vanilla interest rate swaps or currency swaps could easily be valued

by splitting them into a loan leg and a debt leg, measuring both at

amortised cost, and booking the net value.

• This approach would remove a lot of complexity from the financial

statements by allowing for the removal of hedge accounting rules which

are necessary today.

• This is very relevant especially to the accounting for swap instruments

that are associated with financial liabilities.



12

Conclusion

• Rather than

• a new « quick fix » accounting standard on financial instruments

• What we need is

• a new accounting standard adressing financial activities

• an in depth reflection, outside the « full fair value» box , on the

different uses of financial instruments and on the most relevant (the

«fairest») representation of the different financial activities

Documents

Trading and Banking Accounting