3Key Balance Sheet Assets Cash and balances held at central banksLow yields, held to meet statutory liquidity requirementsHighly liquid assets covered in statutory liquidity requirements:Cash and balances held at central banks, government securities, repo securitiesOpportunity cost between low yields and interbank lending rate factored in cost of funding to the users of fundsFormula to factor this cost in cost of funds =[100% x original cost of funds – 10% x (yield of liquid assets – interbank lending rate)]/(100% - 10%)This assumes statutory liquid asset requirement to be 10%.
4Key Balance Sheet Assets (2) Trading assetsHeld for trading and fair valued under IAS 39 and FAS 115 accounting standard classificationse.g. equity and debt securities, reverse repos, loans traded in market(3) Financial assets designated at fair valueElected/designated for fair valuation under IAS 39 and FAS 159Financial assets e.g. available for sale (AFS) securities, securities held for repurchase/resale, loans held for sale, equity investments and loan commitments(4) Financial InvestmentsHeld for maturity securities (debt & equity)
5Key Balance Sheet Assets (5) Loans and AdvancesLoans and advances to banks and non-banksIncludes repos and reverse repos – collateralized borrowing and collateralized lending"Repo 105“ in Lehman treated as sale of inventory on basis of overcollateralization, to reduce leverage ratios.Net carrying amount shown as principal amounts less loan loss allowances/provisions.
6Accounting standards (Securities) IAS 39 & FAS 1143 main categories:(a) Held to maturity: management has intent to hold securities tomaturity, security is accounted for at amortized cost , interest accrued,realized gains/losses on sale of securities,(b) Trading: security held for short term sale purposes, securityaccounted for under fair value accounting,(c) Available-for-sale: neither held for trading or to maturity (statutoryliquidity requirements), changes in fair values recognized in othercomprehensive income & transferred to earnings upon sale of securityImpairment test: if decline in asset deemed to be other than temporary, impairment charge made to income statement.
7Accounting standards (Fair Value Measurement) FAS 157 (exit price in principal or most advantageous market)Level 1 assets- most liquid asset, observable market prices e.g. quoted equities, quoted bonds, spot FXLevel 2 assets- market prices of assets not directly observable, but fair values can be derived from models using directly observable market inputs such as interest rate yield curves and option volatilitiese.g. convertible bonds, interest rate swaps, FX swapsLevel 3 assets- valuation model uses unobservable market data e.g. MBSFair value adjustments for levels 2 & 3 assets: bid-offer spreads, liquiditypremium.
8Accounting standards (Fair Value Measurement) IAS 39Active versus Inactive marketsAssessment criteria:levels of volume and activity,if transaction prices are stale,consistency in price quotes from brokers/market makers,correlations among similar assets,price levels that may indicate liquidity concerns,bid/offer spreads beyond normal dealer profits
9Accounting standards (Fair Value Measurement) Orderly or disorderly transactionAssessment criteria (a transaction is deemed disorderly if a condition issatisfied):Structured product had no sufficient exposure to the market based on usual marketing period,If product has been marketed to single buyer,If seller is in state of insolvency,d) Transaction price is outlier compared to prices of similar productsIf market is inactive and transaction is disorderly,Mark to model is used.
10Accounting standards (Fair Value Option) FAS 159- Intention is to reduce financial statement volatility and reduceonerous documentation requirements under FAS133.- Management given substantial discretion to elect fair valuee.g. assets classified as held to maturity or available for sale, but funded by derivatives.IAS 39- Revision in 2005 allows a firm to designate a financial asset or afinancial liability on initial recognition as one to be measured at fair value.- Designation is irrevocable. Conditions include:selected financial asset/liability must contain embedded derivatives,selected financial liability with amounts contractually linked to valuation of asset at fair value,changes in financial instrument value offset changes in fair values of financial assets/liabilities such as derivatives.
11Accounting standards (Derivative accounting) IAS 39 & FAS 133- Trading derivative fair values recognised in income statement.- Derivatives designated as hedging, accounting treatment as follows:Fair value hedge - derivatives hedge the exposures to changes infair value of fixed rate exposures; derivatives’ gains/losses recognised inearnings.Cash flow hedge – derivatives hedge cash flows of forecastedtransactions (floating rate exposures); derivatives’ gains/lossesrecognised in other comprehensive income.Derivatives hedge foreign currency exposures of net investmentsin foreign operations, derivatives’ gains/losses recognised in othercomprehensive income.Tests of hedge effectiveness based on fair value correlations betweenhedging and hedged items.
12Accounting standards (Derivative accounting) IAS 39 & FAS 133Derivatives embedded in financial instruments (e.g. dual currencydeposits), bifurcation required if embedded derivatives are not related tounderlying host instrument:Host instrument is interest rate related while derivatives are foreignexchange or equity related such as dual currency deposits, equity linkeddeposits;If embedded derivatives are interest rate related, the investor maynot recover substantially the initial investment or the returns of structuredproduct is at least twice that without the embedded derivatives e.g.range accrual deposits.
13Accounting standards (Loan Loss Provisions) IAS 39 & FAS 114- Incurred loan loss allowances/provisions method requires specific andgeneral provisions.- Objective evidence of loss event for specific provisions e.g. paymentdefaults.- Evaluation criteria for general provisions:Risk ratings (external e.g. Moody’s and internal),Loan types (e.g. credit cards versus loans to small corporate),Product lines/industries of borrowers (e.g. volatile industries such as construction or industries in downturn)Geographical segmentsEconomic conditions (current and forecasted)Estimated delinquencies and payment historiesCredit scores of retail customersForeclosure rates for mortgage loans.
14Accounting standards (Loan Loss Provisions) IAS 39 & FAS 114Loan future cash flows discounted at original effective rates to derive theloan asset value and provisions to be recorded.E.g. 5 year loan of £15k to be received at end of each year at originaleffective interest rate of 7%.One year before maturity, evidence of impairment and expected cashflow is £7.5k.PV of loan = £7.5k discounted at 7% = £7kImpairment loss = £15k - £7k = £8k.Interest accrual = £7k x 7% = £490.Incurred loan loss accounting method severely criticised for delayingrecognition of loan losses and being pro-cyclical (Financial StabilityForum 2009; Turner, 2010).
15Accounting standards (Securitization) Securitization: sale of loans and receivables to investors4 players in securitization market:a) Banks – originators of loansb) Securitizers – separate securitization entities that house securitizedassetsc) Investors in securitized assetsd) Guarantors – that provide guarantees or liquidity supportKey accounting question:Should securitized assets in the securitization entity be consolidated?Securitization entity consolidated with issuer when former does not havelegal right to foreclose on the securitized assets.Rapid growth in securitization many securitization entities which donot have such rights were not consolidated. (Ryan, 2008)
16Reform of Accounting standards Revisions to IAS 39 in the following phases (IFRS 9):Phase 1 – derecognition criteria (ED – April 2009)Existing derecognition conditions:any substantial transfer of risks and rewards,who has control over assets,whether transferor has continuing involvement in assets.Revisions – simplify the conditions and use the key tests of control.Phase 2 – classification & measurement criteria (ED – July 2009)Eliminate bifurcation between financial host product & embeddedderivative. 2 conditions of measuring financial asset at amortised cost:when instrument has basic loan featureswhen instrument is managed on contractual basis.
17Reform of Accounting standards Phase 3 – amortised cost & impairmentExpected loan loss modelFuture expected cash flows (factor expected credit loss over life of theloan) at original effective interest ratesRecognition threshold of loss event removed.Key argument against use of fair valuation for mortgage loans isthat they are expected to be held for long term & accounting mismatchesagainst the liabilities (causes earnings volatility that are not related toeconomics).Phase 4 – hedge accounting (ED - 1H 2010)Phase 5 – classification & measurement of liabilities (ED not releasedyet)
18Comparison of Expected Loan Loss versus Incurred Loan Loss models Base case example: 5 year fixed rate loan with principal £1m, coupon rate 10%, 5% expected loss on maturityDeloitte, 2010
19Comparison of Expected Loan Loss versus Incurred Loan Loss models Scenario 1: At start of year 2, expectation of loss revised to be 10% at maturityDeloitte, 2010
20Comparison of Expected Loan Loss versus Incurred Loan Loss models Scenario 2: At start of year 2, expectation of loss revised to be zero at maturityDeloitte, 2010
21Reform of Accounting standards ICAEW proposals (ICAEW, 2010)Auditors may provide assurance on new summary risk statements of banks.Banks should confirm that key areas of judgement discussed with auditors are set out in critical accounting estimates of financial statements. Auditors to be involved in reporting on front sections of annual reports.Regular dialogue between auditors and banking supervisors.Supervisors should tap auditors’ expertise as part of their monitoring regime.
22Sociological Perspectives of Risk Management & Control The Risk Management of Everything (Power, 2004)Rise of Internal Control – critical events: Cadbury Code in 1992 due to collapse of Maxwell Empire, COSO document in USInternal controls turned from private organizational practices to regulatory objects e.g. Sarbanes-Oxley Act in US (turning organizations inside out)Invention of Operational Risk – focus on fraud and infrastructure risk issues under Basel II; Barings case help sell the idea- policy question of implementation effectiveness because mainly on low impact high probability (deviation from norm), not high impact, low probability events- myth of controllability especially in areas such as management culture, “tone at the top”
23Sociological Perspectives of Risk Management & Control 3. Making Risk Auditable: Legalization & Organizationpressures on organizations to manage all risks (more litigiousenvironment)managers of risks more concerned about protecting their own risksexperts made accountable for too much uncertainties, thingsthey do not knowdangerous flight from judgment and culture of defensiveness e.g. debated “tick-box” mentality of auditors not exercising professional skepticismThe Risk Management of Nothing (Power, 2009) challenges the mereuse of metrics in enterprise risk management (ERM) and not recognizingthat risk appetite is dynamic organizational process involving values andthe interconnectedness of risks with external states of world.
24Sociological Perspectives of Risk Management & Control How evaluation practices of ABS/MBS and CDOs lead toarbitrage and credit crisis (Mackenzie, 2010)1. Historical path-dependency of evaluation practicesCDO – primary object is defaultMBS – primary object is prepayment risk (3 governmentsponsored agencies: Ginnie Mae, Fannie Mae, Freddie Mac seen asbacking the mortgages)- Minimal prepayment penalty high prepayment risk- Prepayment option reduces value of MBS- Key skill in evaluation is on prepayment risk
25Sociological Perspectives of Risk Management & Control 2. Evaluation practices oriented towards credit correlationInfluence the creation of tradable credit indices3. Evaluation practices become different organization routines in differentparts of the same organization (banks, rating agencies)e.g. ABS and CDO evaluated by different sections of rating agencies; for ABS CDO, treated as variant of CDO, based on underlying ABS ratings4. Ratings encode default probability and become rules for institutionalinvestors – 74% of US and 78% of European fund managers useminimum rating buying requirement- In US, 100 federal laws & 50 regulations incorporate ratings
26Sociological Perspectives of Risk Management & Control 5. Ratings “black-boxed” complexities of complex instrumentsspreads can be compared across instruments based on spread-rating relationshipsdesign of instruments driven by how they will be evaluated by rating agencies6. Different evaluation practices allow arbitragetranches of CDO at A, AA, AAA give higher yields than corresponding corporate or asset-backed derivativesdefault probability & recovery rate of CDO based on ABS’ ratings and defaultsABS correlations hard to obtain (lack of markets & defaults were rare)Judgment & consistency with ABS correlation, plus competition lead to 0.3 correlation factor by S&P, Moody’s
27Sociological Perspectives of Risk Management & Control Diversifications at ABS level and at CDO level incorporated twice in ratingsTraditional buyers of mezzanine (BBB rated) ABS tranches displaced by ABS CDO managers.ABS CDO managers need to buy “raw materials” (ABS) Demand for ABS > Supply Lend to securitize Loosening of lending standards
28ReferencesDeloitte, IFRS 9 proposals: Accounting for financial instruments following a financial crisis.Epstein, Nach, Bragg, GAAP 2009 Interpretation and Application of Generally Accepted Accounting Principles. John, Wiley & Sons, Inc.Financial Stability Forum, Reporting of the Financial Stability Forum on Addressing Procyclicality in the Financial System.HSBC, Annual Report. <http://www.hsbc.com.>.5. ICAEW, Audit of Banks: Lessons From The Crisis.6. International Accounting Standards Committee (IASC), International Accounting Standard 39.7. MacKenzie, D., The Credit Crisis as a Problem in the Sociology of Knowledge. Working Paper.8. Power, M., The risk management of everything. Demos publication.9. Power, M., The risk management of nothing. Accounting, Organizations and Society 34,10. Ryan, S., G., Accounting in and for the Subprime Crisis. The Accounting Review 83,11. Turner, A., Financial Services Authority Chairman address to the Institute of Chartered Accountants in England and Wales (ICAEW) in London.