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UK FSA’s Turner Talks up the Data Challenges of Altering Accounting Standards

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There is a degree of tension between those seeking to reflect the “truth” with changes to accounting standards and those wishing to reflect the concerns of prudential regulators, according to UK Financial Services Authority (FSA) chairman Adair Turner. In a speech last week to the Institute of Chartered Accountants in England and Wales (ICAEW), Turner discussed the difficulty in revising accounting standards from the regulator’s perspective and the data challenge inherent within this process.

The idea behind revisions to global accounting standards is sound, said Turner, in that it will limit the role of “judgement” within the process, which is something that individuals working in the pricing and valuations space are all too aware of (see our roundtable discussions last year for proof). As noted by Matthew Cox, head of securities data management in Europe for BNY Mellon Asset Servicing, at an event last year, the goal behind any revisions to valuations and accounting standards is to eliminate any need for judgement in the process via a more structured approach.

However, Turner pointed to the two very different points of view in the industry about how to tackle accounting standards from the point of view of regulators and central banks versus that of securities analysts, standards bodies and investors. “Among bank prudential regulators and central banks there is a belief that existing bank accounting standards were among the factors contributing to the crisis, inducing procyclicality in credit provision and pricing. And there is a demand that bank accounting standards must reflect the concerns of prudential regulators. There is a belief that banks are different, and that accounting standards need to recognise this,” he explained.

On the other hand: “Among many securities analysts and investors, however, and among some accounting standards setters, there is a belief that accounts are for investors and not for regulators, that they must tell the ‘truth’ as it exists at one particular point in time, and that any influence of prudential regulators on bank accounting standards could be a Trojan horse for a wider politicisation.”

Turner indicated that there is also a degree of tension existing at the regulatory level with regards to fair value accounting standards that has not yet been dealt with. He separated out the prudential regulators from the securities regulators in terms of these approaches, as well as the International Accounting Standards Board (IASB) and the US focused Financial Accounting Standards Board (FASB). With so much disparity across the industry, it is no wonder the regulatory community has been tied up in the accounting standards debate for over a year.

The difficulty around how to treat bank accounting versus that of other types of firms is key to the future stability of the market, according to Turner. He noted that a joint central bank and prudential regulator approach to the space is required in the long run to avoid any vulnerability to systemic risk. He suggested that the industry should look to the policy documents being drawn up by the Financial Stability Board (FSB) and the Basel Committee for guidance in this endeavour.

Turner highlighted in particular the area of valuations for items that have been marked to market and the treatment of loan losses on banks’ books as issues that require further work from a macro-prudential and macroeconomic perspective. He indicated that in terms of loan losses, the current practices “can contribute to a cycle of self-reinforcing responses which tends to exacerbate the volatility of credit extension and of the economic cycle, both on the way up and the way down”. The current accounting practices are therefore affected to a greater degree by economic cycles, whether it is an upswing or a downswing.

The mark to market approach is also affected by these market dynamics, noted Turner, as the approach: “clearly creates dangers of procyclicality both on the way up and the way down, but with the effects even stronger and more disruptive than in the case of the banking book, as a result of the particularly procyclical tendencies of securitised credit extension”.

However, rather than tackling these issues purely through accounting standards revisions, Turner suggested that this procyclicality should also be addressed through other means such as countercyclical and liquidity standards. “It may be that there are problems here, exacerbated by accounting treatment, but that no feasible alternative accounting treatment exists which would help solve these problems without creating others,” he said. This is especially the case for illiquid securities where fair value is the only option.

A combined approach to the overall problem, with the global harmonisation of accounting standards and the introduction of new capital and liquidity standards, should be adopted, Turner contended. However, in terms of the loan losses issue, the FSA recommends a couple of specific changes: “The FSA’s ideal preference would be to provide not one but two separate lines of account information on loan loss provisions. The existing line, based as now, on the facts of already incurred credit impairment events. And a separate line, based either on a formula, as in Spain, or on the judgements of management, challenged by regulators, and with the details, basis and rationale for that judgement extensively disclosed.”

The provision of yet another data set to indicate what the loan losses accounting calculations are based upon would therefore provide an extra level of transparency to the regulators and the market as a whole. However, Turner also notes that there are still “multiple and unstable equilibria” in the mark to market process that cannot be eliminated due to the “nature of information flows about market values”. These values, by nature, are based on data that is constantly in flux and full transparency can therefore influence the collective behaviour of the market itself.

Given the complexity of the issues, it is likely debate will continue for some time about the approach best suited to the market. In the meantime, the valuations and pricing teams of financial institutions will have to keep abreast of any potential developments, while dealing with the plethora of approaches being adopted by each national regulator.

Turner’s full speech is available to view here.

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