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

2 Agenda 1.Interaction between financial reporting and prudential reporting 1.IFRS and prudential reporting 2.Bridging the gap: filters, guidance, templates 2.IAS 39: supervisory response 1.Impact on regulatory capital 2.Loan loss allowance guidance 3.Work ahead 3.Need for robust audit: recent initiatives

3 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

4 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-senstive  Pillar 1 (IRB-approach, operational risk), Pillar 2 assessment, Pillar 3 disclosures But…

5 IFRS and prudential reporting … 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

6 IFRS and prudential reporting … 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 reporting  Regulatory capital is computed using explicit risk weightings

7 IFRS and prudential reporting … and differences in presentation  Financial reporting is becoming less specific in form  No specific standard for banks  No specific reporting formats

8 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)

9 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

10 Prudential filters Maintain level of regulatory capital Examples:  Deduct goodwill  Maintain 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

11 Prudential guidance Prudential filters not preferred route in all cases  Exploit strengths of financial reporting  Recognise reporting burden on banks Apply prudential guidance where this solves the problem  Accept financial reporting if subject to robust risk management consistent with prudential norms  If not, consider prudential measures

12 Prudential reporting templates FINREP (FINancial REPorting framework): based on IFRS COREP (COmmon REPorting framework): based on CRD  Promote convergence of supervisory practices  Promote harmonisation of information  Facilitate exchange of information  Reduce reporting burden on banks operating cross- border

13 Agenda 1.Interaction between financial reporting and prudential reporting 1.IFRS and prudential reporting 2.Bridging the gap: filters, guidance, templates 2.IAS 39: supervisory response 1.Impact on regulatory capital 2.Loan loss allowance guidance 3.Work ahead 3.Need for robust audit: recent initiatives

14 Overview 1.IAS 39 has merits and drawbacks for the prudential supervisor 2.Supervisory response is necessary 3.IAS 39 is an ongoing project

15 Impact on regulatory capital Qualitative analysis indicated need for response  Press releases (prudential filters)  Prudential guidance (fair value option, loan loss allowances) Quantitative analysis (CEBS) indicated need for monitoring  Fair value option  Loan loss allowances  Hedge accounting

16 CEBS impact analysis (transition) ∆(%) Financial assets (HFT)9771,69674 Financial assets (FVO) Financial assets (AFS) Loans and receivables4,8704,717-3 Financial assets (HTM) Financial liabilities (HFT)5691, Hedging derivatives (liabilities)1362,531 In billions of euros

17 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

18 Regulatory response: what? Prudential filters (treated earlier) Prudential guidance  Fair value option guidance (under consultation)  Loan loss allowance guidance (under consultation)

19 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

20 Loan loss allowance guidance (2) Content of the guidance  Ten principles covering  Supervisory expectations  Supervisory action  Highlight differences between financial reporting framework and prudential framework  Encourage use of common inputs for credit risk assessment, financial reporting and prudential reporting

21 Loan loss allowance guidance (3) 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

22 Loan loss allowance guidance (4) Implementation of the guidance  Process review  Dialogue with external auditor  Dialogue with prudential supervisor  Dialogue between external auditor and prudential supervisor

23 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

24 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

25 Agenda 1.Interaction between financial reporting and prudential reporting 1.IFRS and prudential reporting 2.Bridging the gap: filters, guidance, templates 2.IAS 39: supervisory response 1.Impact on regulatory capital 2.Loan loss allowance guidance 3.Work ahead 3.Need for robust audit: recent initiatives

26 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

27 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

28 Recent initiatives in audit Regulatory intervention Introduction of oversight: PCAOB (US), EGAOB (EU) Revised legislation (EU 8th Directive)

29 Recent initiatives in audit 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)

30 Recent initiatives in audit IFAC technical reform Revised Code of Ethics Clarity Project Review of standards Explicit identification of public interest entities Focus on conduct, including corporate conduct

31 EU 8th Directive Formal adoption foreseen in 2006; transposition into national law within two years 1.Independent public oversight 2.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 body 5.Limited liability (EC invited to issue report before end 2006)

32 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