Earlier this week, the U.K. Financial Services Authority (FSA) released The Turner Review: A Regulatory Response to the Global Banking Crisis. Props to Martin Wolf and Jennifer Hughes of the Financial Times for reporting on issuance of the FSA's report, in Wolf's article on March 20, Why The Turner Report is a Watershed for Finance, and Hughes article March 19, Accounting Plan Sparks Strong Debate.
As noted in the FSA's press release, "Lord Turner, chairman of the FSA, was asked by the Chancellor of the Exchequer to review the events that led to the financial crisis and to recommend reforms. The Review identifies three underlying causes of the crisis:
· macro-economic imbalances,
· financial innovation of little social value and
· important deficiencies in key bank capital and liquidity regulations"
" These were underpinned by an exaggerated faith in rational and self-correcting markets," the FSA states. Therefore, the Turner Review "stresses the importance of regulation and supervision being based on a system-wide "macro-prudential" approach rather than focusing solely on specific firms."
Concurrent with release of The Turner Review (aka the Review), the FSA issued a Discussion Paper (DP 09-2) to obtain comment by June 18 on the recommendations in the Review.
As summarized in this FSA newsletter: "The [Turner] Review sets out a wide-ranging series of changes that are needed to banking regulation and associated supervisory practice. In some areas the FSA can and will take action on its own, but in others international agreement will be needed. In particular:
- fundamental changes are needed in the regulatory approach to capital, liquidity and accounting;
- there needs to be a system-wide approach to identify and deal with macro-prudential risks, to complement stronger micro-prudential supervision of individual firms;
- changes need to be made to the scope of regulation to make sure that the economic substance of activities are regulated, not the legal form; and
- the international framework for the regulation and supervision of cross-border banks needs strengthening in the light of the crisis. As part of this the Review recommends a new European body which will be both a standard setter and overseer in the area of supervision.
"Hard-wired procyclicality" and inadequate capital buffers were among the factors which exacerbated the financial crisis, according to the Turner Review. Additionally, the report states that the growth of financial services as a % of GDP was fueled by "illusory effects" of mark-to-market in a rising market, specifically, that: "mark-to-market accounting helped fuel a self-reinforcing cycle of irrational exuberance," and there were 'harmful effects' of 'rent extraction.'
On this second point, the report notes: 'some and perhaps much of the structuring and trading activity involved in the complex version of securitised credit, was not required to deliver credit intermediation efficiently. Instead, it achieved an economic rent extraction made possible by the opacity of margins, the asymmetry of information and knowledge between end users of financial services and producers, and the structure of principal/agent relationships between investors and and companies and between companies and individual employees." The report continues: "when the crisis broke, banks did not have sufficient capital buffers to absorb losses, creating the danger of a self-reinforcing feedback loop between weak lending capacity, economic recession, and credit losses."
The Turner Review (the 'report') concludes these and other factors have implications for regulation, and offers seven recommendations to creating a sounder banking system:
1. Increasing the quantity and quality of bank capital.
2. Significant increases in trading book capital: and the need for fundamental review.
3. Avoiding procyclicality in Basel 2 implementation.
4. Creating counter-cyclical capital buffers.
5. Offsetting procyclicality in published accounts.
6. A gross leverage ratio backstop.
7. Containing liquidity risks: in individual banks and at the systemic level.
The accounting-related recommendations are discussed in Section 2.2. of the report (beginning on printed page 61; pdf page 63). These include consideration of: Dynamic Provisioning for loan loss provisions, described as: "a statistical method to allow for losses inherent within the portfolio which have not yet materialised. In economic upswing, it builds up a buffer by requiring provisions higher than recognised by standard ‘incurred loss’ accounting. In economic downswing, it allows some losses to be met from the accumulated buffer."
However, the report states "there are legitimate concerns that if management were able to provision in advance for future possible loss, it would have a cushion which it could use to hide the impact of losses subsequently arising, including losses which were idiosyncratic in nature, i.e. linked to bad decisions made by the individual bank, rather than reflective of a general economic downturn."
Yet, the report states (printed pg 65, pdf pg 67) that while the current approach of marking the trading book to market and provisioning for incurred losses in the banking book, "is appropriate viewed from an idiosyncratic perspective – an individual bank operating in a reasonably stable financial and economic environment – from the point of view of regulators, and of systemic financial risk, it has serious disadvantages. On both the trading book and banking book side, it can fuel systemic procyclicality."
Therefore, the Turner Review recommends "creation of a non-distributable Economic Cycle Reserve, which would set aside profit in good years to anticipate losses likely to arise in future." This is described in detail on pg printed pg 66 (pdf pg 68) of the report, which concludes:
"The appropriate way forward on accounting now needs careful debate between
regulators and the bodies which ultimately set published account standards (the
International Accounting Standards Board and the Financial Accounting Standards
Board). But the FSA position is in principle clear: we believe it important that
the counter-cyclical approach to bank capital is reflected in a significant way
in highly visible published account figures, creating strong shareholder and
management awareness of the need to assess profitability in the light of the
position in the economic cycle."
The subject of dynamic provisioning has been discussed by the FASB-IASB Financial Crisis Advisory Group, and the topic of loan loss provisions is on the agenda for this week's FASB-IASB joint board meeting in London (see agenda papers 7, 7A-7E on provisioning).
Separately, the IASB on Friday issued a Request for Views on FASB's recent proposals on fair value in inactive markets and other-than-temporary impairment (OTTI). The IASB states "Feedback from interested parties will be considered by the IASB before deciding whether to publish formal proposals for public comment," adding, " Any proposed changes in International Financial Reporting Standards (IFRSs) will be subject to due process."
The comment deadline on IASB's Request for Views is April 20, and the comment deadline to FASB on its Proposed FSPs on fair value and OTTI is April 1. As noted at FASB's board meeting last week, the board plans to meet on April 2 to decide on final standards in this area. Further background on FASB's proposals can be found here, here and here.
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