Regulators and Fair Value Gains
To understand why bank regulators mistrust fair value from unlisted instruments consider an Investment Bank which has assets only in unlisted financial instruments such as private equity, real estate, structured products such as CDOs. Under IAS 39, the bank can designate these assets as FVTPL (fair value through profit and loss) which means that the gains from these assets can be taken into the P&L (unlike available for sale (AFS) assets where the gains are taken into balance sheet).
From a regulators perspective the danger arises in the following way: The bank can inflate gains by using an appropriate valuation process in unlisted instruments and recognize it as income on a quarterly basis. This then gets routed into Tier one equity by the end of the year, which is considered as core capital. Now if the banks core capital has a high proportion of unrealized gains (which could happen in a boom period), the danger is that is a kind of notional capital which is not really available to support the bank in a down turn. Note that regulators have no issues with realized gains which gets routed into capital as these are real and not notional.
So what regulators want is that the fair value gains from unlisted instruments should be totally disregarded for regulatory capital computation purposes. On the flipside losses are passed on into the P&L in toto; thankfully there is no up scaling factor! So in effect, the upside is subject to a haircut before inclusion into P&L, while the downside is fully passed into the P&L.
In practice, regulators normally propose is a blanket haircut on the unlisted gains before taking into capital. For example in Bahrain, banks are required to recognize only 45% of the gains from unlisted instruments. This is a prudent approach but banks like in the above example would be hit.
There is a way out: if regulator is convinced that there are adequate safeguards in the form of a strong risk management framework and reliable and consistent valuation methodology for the unlisted instruments, then a lower discount factor could be applied. This approach additionally provides incentives for banks to strengthen risk management and valuation techniques.
What are the implications for the regulator and banks?
From the regulatory perspective, the use of fair value option throws up an additional challenge for regulators to get on top of valuation methodologies and accounting standards such as IAS 39 and IAS 32.
To apply a blanket haircut and then claim to be prudent is not difficult. The real challenge is in exercising judgment on relaxing the haircut on a case by case basis. The importance of regulatory judgment is thus further underscored in the Basel II era, especially with regulators deciding on capital levels for banks on a case by case basis rather than through a spreadsheet calculation for all banks under Basel I. (see my earlier blog: The Brave New World of Basel II)
Investment Banks which have a majority of assets under FVTPL will face the challenge of volatile capital adequacy ratios this is evident in case of large US investments banks which have raised additional core capital to bolster capital adequacy ratios. On the upside, banks may want to strengthen risk management and valuation frameworks to gain regulatory approval.
Basel & Accounting for Intangibles
Intangible assets are assets (other than financial assets) that lack physical substance yet do have utility and value in the hands of the reporting entity. Some examples of intangible assets in financial institutions are: customer relationships, continued access to stable and cheap deposit base. More than the reported profitability, intangible assets often are the main drivers behind mergers and acquisitions in the banking sector.
The problem crops up for the acquiring bank which may end up with considerable intangible assets on its balance sheet. The standard regulatory treatment for goodwill - which is one kind of intangible asset - is to deduct it from the capital, no questions asked. The key reason: can this asset provide support during times of financial distress? Apparently, the regulators think it cannot!
Will this treatment be extended to other forms of intangible assets such as customer relationships, core deposit base, etc? Answer: go and ask your regulator!
In jurisdictions like Singapore, Hong Kong, Australia, New Zealand, and the United Kingdom, regulators have prescribed that all forms of intangible assets should be deducted from the capital (same treatment as goodwill).
This indeed is backward looking as it would appear that while accounting standards have evolved, regulatory standards have not. The sole exception to this is the Fed Reserve whose rule book states that this would be evaluated on a case by case basis and not through a blanket deduction approach.
Banks which plan to acquire other banks must therefore be on the guard about the possible implications of acquiring intangible assets. There could be a double whammy: banks could overpay for the intangible asset and end up with a below par capital adequacy ratio after the regulator applies the deduction rule on all intangibles.
Consult your regulator before you shop for banks - that is the broad message!
