By Dwight Cass
FASB and the IASB are slowly refining the standard, but this more realistic accounting approach will hit bank capital—and could cause lenders to pull in their horns even more.
The last time the International Accounting Standards Board (IASB) and the US Financial Accounting Standards Board (FASB) made reportable progress on their financial asset impairment project was before the August 2011 flare-up in the European sovereign debt crisis. Revelations about the extent of European banks’ exposure to dodgy PIIGS debt, and how this has imperiled not only the banks but the euro itself, have cooled some of the enthusiasm for an accounting move that, while perhaps more realistic and useful for investors, will almost certainly squeeze bank capital by requiring more loan-loss provisioning at an earlier stage in an asset’s deterioration.
Given the sluggish pace of the impairment project (and most of the other joint FASB-IASB initiatives) and growing disillusionment among US accountants and standards-setters regarding the overall goal of accounting convergence, banks may not have too much to worry about. The earliest a new standard could be implemented is in 2013. And more refinement needs to be done before the standards-setters issue the next exposure draft on this subject, expected some time in the first half of this year.
The existential threat to European banks last autumn from sovereign credit risk that current accounting standards did not require them to acknowledge shows that getting impairment accounting right is and should remain a priority. Nonetheless, if banks squawk loudly enough, regulators on both sides of the Atlantic, who have already proven themselves willing to fudge stress tests and hide massive bank funding programs, might cast a gimlet eye on the project.
Banks are concerned that the proposed “three-bucket” impairment standard, by recognizing expected losses before they have been incurred, will force them to boost their loan loss reserves earlier, at the expense of capital, which will already be stretched by Basel III and related measures. Ernst & Young, in a survey of 10 large European banks it conducted in August 2011, stated:
“All respondents told us that the three-bucket credit impairment approach will have a significant impact on the level of provisions held. Some organizations also believe that provisions will often be greater-than-expected loss calculations used for capital adequacy tests and therefore will result in a reduction of the surplus of regulatory capital over required capital levels under Basel III.”
If so, banks will have to raise even more capital than currently projected under Basel III and national “finishes”, further gutting their returns on equity and making it more difficult to lure in shareholders.
The three-bucket credit impairment approach will have a significant impact.
The fear is that banks, with their risk-taking nails soon to be clipped further by regulators, will become extremely leery of the sort of capital-intensive activities for which corporate treasurers regularly turn to them.
Alone Together
The impairment project is picking up steam just as US regulators are becoming leery of further convergence. The quality, they say in private, of IFRS standards is a major concern, and they would prefer to keep US GAAP than peremptorily hitch the US accounting standards to IASB rules when the benefits of such a move are beginning to seem increasingly theoretical.
But this project is of particular importance, given the difficulty investors and counterparties had during the financial crisis when they attempted to glean the true health of the banks. So even if overall FASB/IASB convergence gets back-burnered, coordinating the handling of financial asset impairment will remain a priority.
PricewaterhouseCoopers partner Gregory McGahan and senior manager Jivka Batchvarova wrote, in an update they issued after the December meeting, “Both boards continue to strive to achieve convergence in this area as constituents believe that achieving convergence on the impairment model is critical. The tentative decisions made this week indicate that the boards may be one step closer to achieving this goal.”
FASB fights To Protect its Turf
The US accounting standard setter responded in November to the SEC’s “condorsement” approach to the convergence of US GAAP and IFRS, saying it needed to be amended to avoid the loss of regulatory authority.
The condorsement proposal, floated by the SEC in May 2011 in a staff paper, essentially would:
- Incorporate IASB standards into US GAAP
- Transfer oversight authority from single regulators (such as the SEC) to a multinational regulator
- Cede much of the design of accounting standards to the IASB, with FASB given the chance to “endorse” rules once they’re complete and before they are applied in the US (hence “condorsement” from convergence + endorsement)
The trouble with this is FASB would be forced to make a yes-or-no decision at the end of the process, rather than having control all along, and would therefore be somewhat “railroaded” into endorsing rules it might not be entirely comfortable with. Condorsement also reduces FASB and the SEC oversight authority. And the plan would rapidly set up international governance, which given the IASB’s mixed record on timely rule design, seems unwise.
In its November comment letter, FASB argued for more authority for national standard setters, more independence for rulemakers in general—a reference to the IASB’s politically charged decision making, and more influence for FASB staff within the IASB.
Kick the Bucket
Banks have a number of concerns about the impairment approach, reflected both in their responses to the E&Y survey and in their comment letters. A leading worry is ensuring the bucket approach can be coordinated with their internal credit modeling and management. This means they oppose a “bright line” approach, which would decree some threshold trigger for moving an asset from one bucket to another. The FASB and IASB have provisionally agreed to allow banks latitude in this area.
Another concern is the possibility that the rule forces a move from Bucket One to Bucket Two too soon, in cases where the loan may recover and be moved back into the first bucket. Banks told E&Y in its survey that this will “create significant volatility in the income statement,” and that, “Institutions are also concerned that this would lead to significant volatility in regulatory capital, which is likely to be pro-cyclical rather than counter-cyclical.”
Another bank concern is with the three-bucket approach itself. Banks’ operations are often set up for a good-book, bad-book taxonomy, and about half the respondents to E&Y’s survey last August said the cost of the switch to three buckets was not justified by any benefit such an approach might yield.
With IASB and FASB making notable progress on the impairment standard, despite the languid pace and the worries of the banks, it would be well for corporate treasurers to keep a close eye on the developments over the next six months, to get a feel for how the standard will emerge, impact banks’ capital and therefore banks’ interest in extending their balance sheets.
BUCKET BUSINESS
At their joint meeting in mid-December, the IASB and FASB boards made the following decisions regarding the joint impairment accounting standard. The boards:
- Decided that the objective of the first bucket would be to capture the losses on financial assets expected in the next twelve months. Previously, they had considered 12 and 24 months. The banks in Ernst & Young’s survey unanimously backed the 12-month option, saying the approach aligns better with existing Basel II expected loss forecasts and other forecasts they perform.
- Agreed to measure the lifetime expected losses on the portion of financial assets on which a loss event is expected over the next 12 months.
- Agreed that the financial assets would move out of Bucket One when “there is a more than insignificant deterioration in credit quality since initial recognition and the likelihood of default is such that it is at least reasonably possible that the contractual cash flows may not be recoverable.”
- Decided that recognition of lifetime expected credit losses would be based on the likelihood of not collecting all the cash flows, rather than using a loss-given-default method.
- Agreed to offer examples of when recognition of lifetime expected losses would be appropriate.
- One big problem with deciding when to move assets out of Bucket On is how to bundle small ones together in a rational manner. The boards decided upon the following principles: > Assets are to be grouped on the basis of ‘shared risk characteristics’.
> An entity may not group financial assets at a more aggregated level if there are shared risk characteristics for a sub-group that would indicate that recognition of lifetime losses is appropriate.
> If a financial asset cannot be included in a group because the entity does not have a group of similar assets, or if a financial asset is individually significant, an entity is required to evaluate that asset individually.
> If a financial asset shares risk characteristics with other assets held by an entity, the entity is permitted to evaluate those assets individually or within a group of financial assets with shared risk characteristics.