March 29, 2008
Closer look at Intangibles need of the hour
In recent times, regulatory talk on productivity of organisations have zeroed in on one significant development of the "new economy" - the steady rise to prominance of intangible assets- assets that can not be seen physically or difficult to map on the balance sheet, but whose impact is felt in the performance of the organisation. Bernanke talks about its rise to prominance in the US ( Remarks by Mr Ben S Bernanke, Chairman of the Board of Governors of the US Federal Reserve System, before Leadership South Carolina, Greenville, South Carolina, 31 August 2006.) ; Svante Oberg, Deputy Governor of the Sveriges Riksbank, highlights the role of intangibles at a meeting arranged by Danske Bank, Stockholm, 29 January 2008; and Deutschebank comes up with a detailed analysis on intangibles " Value Intangibles" ( Deutsche Bank Research 7,October 19, 2005).
As a matter of fact, financial accounting standards have improved significantly over the last decade or so and sort of converged on the view that intangible assets are as important as tangible assets. Any intangible asset that is associated with contractual or legal rights, such as a trademark, patent or copyright, must be recognized as value enhancing assets for the organisations.
The treatment of intangible assets however vary from a capital adequacy perspective in so far they have to be deducted from Tier 1 capital when it comes to calculating the capital adequacy number. Expressing the overarching view that intangible assets should be deducted from Core capital for capital adequacy purposes as one is not sure how much of such assets can be effectively utilised to pay back depositors for a bank in distress, it explicitly leaves the issue for national discretion due to divergences in regional accounting standards and divergent role of intangibles in advanced and emerging economies.
Thus, in the treatment of Intangible Assets for Capital Adequacy, regulators are left with two choices, a) to treat them as part of core capital or b) as part of other assets with appropriate risk weighting. While one would guess that in modern knowledge driven economies such intangible assets such as human capital will be treated as part of the capital base, surprisingly, Basel II has been static in this respect. And while a difference in the recognition of intangible assets can have enormous implications for the capital adequacy ratios, not significant attention has been paid by Basel II on this issue and the broad outline of the basel I guideline still previls.
International Best Practices thus exhibit a high degree of conservatism in the non-recognition of intangible capital and their value generating capabilities. This view cuts across economies of advanced and emerging markets. For instance,in jurisdictions like Singapore, Hong Kong, Australia, New Zealand, and the United Kingdom, regulators have prescribed that all intangible assets should be deducted from the capital.
The modern view, and perhaps the more realistic one, is slowly but steadily gaining ground. Some banking regulators such as the United States ,Canada and France have started recognising the role of value creating intangible assets and have exempted intangibles from deduction rules in capital adequacy. In Canada for example, intangible assets in excess of 5% of gross Tier 1 capital are to be deducted from Tier 1 capital. In France, any Leaseholding in foreign currency is treated as part of Tier 1 capital and hence not deducted.
And in the USA, banking supervisors have a more granular approach and a diverse approach in the treatment of intangible assets. While The Federal Reserve prescribes that intangible assets associated with mortgage and non-mortgage servicing Assets and credit card relationships to be included in assets (i.e., not be deducted for capital adequacy purposes), subject to certain limits.
The aggregate regulatory capital limit on these two categories of assets is 100 percent of Tier 1 capital. However, within this overall limit, nonmortgage servicing assets are combined with purchased credit card relationships and this combined amount is limited to no more than 25 percent of an institution's Tier 1 capital.
In modern technology and knowledge driven financial systems, intangible assets have started playing an increasingly important role in economic progress. They are far more transparent thanks to superior accounting rules,and many previous concerns about realisability of predicted cash flows from intangibles have been adequately addressed. However, the consolidation and deduction rules for calculating the CAR number have broadly remained static under Basel I and Basel II accords.
Regulators worldwide have used national discretion to come up with their own treatment of intangible capital and a diversity of practices in the treatment of intangible assets exist for arriving at regulatory capital ratios under Basel II.
There is certainly a need for regulatory rethinking in this regard, and one hopes that one need not wait for Basel 3 to get some concrete guidance or research studies from the Basel Committee in this respect.
Posted by sunandoroy at 11:07 PM
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March 28, 2008
ICAAP Forecasting- The First Critical Step for Business Planning
More and more banking regulators are coming up with their own versions of the high level Pillar 2 guidance provided under Basel 2. APRA came up with their guidance to ADIs in end 2007, Central Bank of Bahrain issued their Pillar 2 directive in January 2008 and the Reserve Bank of India has come up with their Supervisory review process circular yeaterday. Now we have Pillar 2 guidelinesfrom different part of the world and not just Europe, the leaders of the pack.
The overarching philosophy in all these documents is the same - an effort to bridge the gap between regulatory and economic capital through a comprehensive assessment of all material risks facing the organisation and planning the capital as a cushion against unexpected risks.
As you would expect, the work on ICAAP starts early on, alongwith the preparation of the business plan at the beginning of the year. It is important for any bank to have a fully integrated capitl forecast for the financial year that on one hand looks into capital availability based on expected growth of business, profits and dividends and projection of capital requirements for the firm based on the quantification of risks on the other hand . If capital requirement is onot in sync with the capital availability, the organisation may face trouble in the capital management process.
Preparing an ICAAP forecast therefore is a forward loking process starting early on in the entire ICAAP initiative. It may not be as full blown an initiative as the ICAAP document in itself, but a first cut esimate based on several assumptions about businesss profile and estimated growth, emerging macro and micro risks, broad trends in each risks, some assumptions about their correlation structure .
An ICAAP forecast should be an information in the hands of the Board while preparing the business plan while the ICAAP will be a document which will base itself on the business plan of the firm. The two documents are complementary to each other, fulfils different objectives, differ in their degree of details and assumptions. While there is a fair degree of clarity o how an ICAAP document should be arrived at, there is a lack of clarity on ICAAP forecasting as a first step for business planning. As Banks soli their hands in ICAAP preparation, and regulators enter the field for the supervisory review, the issue of forecasting the ICAAP will inevitably come to the fore.
Posted by sunandoroy at 08:31 AM
