1. PwC Caribbean Association of Indigenous Banks "The Applicability of IFRS to the Regional Financial Services Sector" Marking to Market: The Impact on the Financial Statements November 2006

2. Agenda/Contents 1. What is “marking to market”? 2. Why did the IASB introduce the use of fair values? 3. How have they sought to achieve this? 4. How is fair value determined under IFRS? 5. How has this worked; what are the results? 6. What are the challenges in the Caribbean?

3. What is “marking to market”? Marking to market Recording the price or fair value of a security, portfolio or account on a regular basis, to calculate profits and losses or to confirm that margin requirements are being met. Fair value Fair value is the amount for which an asset could be exchanged between knowledgeable, willing parties in an arm’s length transaction. 1

4. Why did the IASB (previously IASC) introduce the use of fair values? Agreement in 1995 with the International Organisation of Securities Commissions (IOSCO) on work programme to complete a core set of International Accounting Standards; Required by IOSCO for cross-border capital raising and listing purposes in all global markets; Core standards included a standard on recognition and measurement of financial instruments, off-balance sheet items, hedging and investments; 2

5. How have they sought to achieve this? Worked jointly with the Canadian Institute of Chartered Accountants to produce a discussion paper in 1997 which suggested that measurement of all financial assets and liabilities at fair value is necessary to obtain consistency and relevance to users; However, based on feedback:  Application of the concept to some industries and to some kinds of financial assets and liabilities will present difficulties;  There was widespread unease about the prospect of including unrealised gains, particularly on long-term debt, in income as proposed;  No country had standards in place or proposed that were similar. 3

6. How have they sought to achieve this? (Continued) Completion of single comprehensive IAS on financial instruments in the timeframe required by IOSCO was not a realistic possibility; Nonetheless, the ability to use IASs for investment and credit decisions and securities offerings and listings was urgent for both investors and business enterprises; Therefore, on 15 March 1999, the IASC issued an interim standard, IAS 39, which was effective for financial statements from 2001. 4

7. How have they sought to achieve this? (Continued) Although not as far reaching as the discussion paper, IAS 39 significantly increased the use of fair values in accounting for financial instruments including all derivatives, assets held for trading and available for sale and certain embedded derivatives; The three classes of financial assets that remained at cost were loans and receivables, fixed maturity investments that the entity intends to and is able to hold to maturity and unquoted equity investments whose fair value cannot be reliably measured; Essentially, this created a fair value option, with a further option as to whether changes in fair value should be reported in profit or directly in equity (ie balance sheet). 5

8. How have they sought to achieve this? (Continued) Since its issue, there have been changes to IAS 39 to “reduce complexity by clarifying and adding guidance and eliminating internal inconsistencies”; In particular, there have been changes, as recent as June 2005, to control the use of fair value options in response to concerns raised by prudential supervisors of banks, insurers and securities companies over the potential inappropriate use of the fair value option. 6

9. How have they sought to achieve this? (Continued) Excluded From Presentation Note that 33 of the existing 38 IFRSs still in effect today include in some way the concept of fair value; For the purposes of this presentation, only 1 standard albeit the most significant standard arguably for banks, has been addressed……IAS 39. 7

10. How is fair value determined under IFRS? Methods for fair value determination prescribed by the standards in order of acceptability are: 1. Quoted prices in an active market; 2. Valuation techniques: a) value in recent arms length transactions; b) current fair value of similar instruments; c) discounted cash flow analysis; d) option pricing models; e) other proven techniques commonly used by market participants. 8

11. How is fair value determined under IFRS? (Continued) Active Market: Quoted Price The objective is to arrive at the price at which the transaction would occur at the balance sheet date in that instrument in the most advantageous active market to which the entity has immediate access. A financial instrument is regarded as quoted in an active market if quoted prices are readily and regularly available from an exchange, dealer, broker etc and those prices represent actual and regularly occurring market transactions 1 on an arm’s length basis. No adjustments to or deviations from the quoted price are allowed for large holdings as a published price quotation in an active market is the best estimate of fair value. 9

12. How is fair value determined under IFRS? (Continued) No Active Market: Valuation Techniques The objective is to establish what the transaction price would have been on the measurement date in an arm’s length exchange motivated by normal business considerations; Valuation technique should make maximum use of market inputs, and relies as little as possible on entity-specific inputs; Expected to arrive at a realistic estimate of fair value if it reasonably reflects how the market could be expected to price the instrument and represents market expectations of the risk-return factors inherent in the financial instrument 2. 10

13. How is fair value determined under IFRS? (Continued) No Active Market: Valuation Techniques (Continued) Assumption is that the entity is a going concern without any need to liquidate, to curtail materially the scale of its operations or to undertake a transaction on adverse terms; Periodically, an entity calibrates the valuation technique and tests it for validity using prices from any observable current market transactions in the same instrument 3 ; The best evidence of fair value at initial recognition is the transaction price unless the fair value is evidenced by comparison with other observable current market transactions in the same instrument; 11

14. How is fair value determined under IFRS? (Continued) No Active Market: Valuation Techniques (Continued) The same information may not be available at each measurement date. No new transaction information may be available after the transaction date. An entity may not have information from recent transactions to determine the appropriate credit spread over the basic interest rate to use in determining a discount rate for a present value computation. It would be reasonable to assume that in the absence of evidence to the contrary, that no changes have taken place in the spread since the transaction date. However, reasonable efforts should be made to determine whether there is evidence of changes. 12

15. How is fair value determined under IFRS? (Continued) No Active Market: Equity Instruments Fair value considered reliable if:  The variability in the range of reasonable fair value estimates is not significant for the instrument, or  The probabilities of the various estimates within the range can be reasonably assessed and used in estimating the fair value; If not considered reliable, the entity is precluded from measuring the instrument at fair value; 13

16. How is fair value determined under IFRS? (Continued) Inputs To Valuation Techniques Basic or risk-free interest rates – Government, LIBOR, highest rated corporate bond if better than Government. Yield curve of interest rates for different time horizons required 4. Credit risk – Premium over the basic interest rate for loans of various credit ratings 5. Foreign exchange rates Volatility Prepayment risk 14

17. How has this worked; what are the results? Some volatility in the balance sheet size (mainly assets and shareholders’ equity); Some volatility in profitability, moreso for those entities with significant derivative positions or trading portfolios; The fundamental question though is………. Do users, and principally investors, now have better information with which to make more informed investment and credit decisions? ………. The investors and analysts must speak up and the profession must listen! 15

18. What are the challenges in the Caribbean? 1. Active market concept requires regularly occurring market transactions; are all securities on the Caribbean stock exchanges actively traded? 2. Valuation techniques require knowledge of market expectations of the risk-return factors inherent in the financial instrument; are our markets sufficiently sophisticated? 3. Valuation techniques need to be tested periodically for validity using prices from any observable current market transactions in the same instrument; do such transactions take place with sufficient regularity? 16

19. What are the challenges in the Caribbean? (Continued) 4. A fundamental input into valuation techniques is a risk-free rate of interest; do risk-free interest rates exist for all durations required? 5. Credit ratings and the determination of credit risk spreads required to establish the premiums to be added to risk-free rates in arriving at discount factors for use in discounted cash flow valuations; is there sufficient information available to make reliable estimates? 17

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