IFRS and Basel 2

1. IFRS and Basel 2 Ian Michael Accounting and Auditing Policy Department Financial Services Authority Contact: ian.michael@fsa.gov.uk

2. IFRS and Basel 2: Key themes • Widespread adoption of IFRS • Interaction of IFRS with existing regulatory rules • Interaction of IFRS with Basel 2 • Disclosure requirements

3. Widespread adoption of IFRS • IFRS increasingly becoming global standards • Adoption in EU from 2005 (mandatory for group accounts of listed companies) • Now used in nearly 100 countries

4. EU Experience • Adoption of IFRS appears to have gone quite smoothly, even though differences from national GAAPs often significant

5. Typical differences between IFRS and national GAAPs relevant to financial sector • Valuation – especially use of fair values • Classification of financial instruments • Hedge accounting • Consolidation • Netting

6. Interaction of IFRS with existing regulatory rules • Definition of regulatory capital • ‘Prudential filters’

7. Definition of regulatory capital • IFRS (IAS 32) will sometimes indicate a different split between equity and liabilities than national GAAP • However, definition of regulatory capital driven to a considerable extent by the Basel Accord • Note that regulatory capital includes some elements which are unquestionably accounting liabilities, eg subordinated debt • However, impact of IFRS on measured equity is the key reason for prudential filters

8. Prudential filters (1) • Cash flow hedges. Under IAS 39, cumulative fair value gains/losses on hedging instruments are recognised directly in equity, to the extent hedges are effective But such gains/losses excluded from regulatory capital • Application of fair value option to an institution’s liabilities. Gains/losses arising from changes in an institution’s own credit risk are excluded from regulatory capital

9. Prudential filters (2) • Available – for – sale instruments • loans • debt securities • equities • Own – use and investment properties

10. Two important areas of difference between prudential and accounting treatments • Securitisations • Netting

11. The Fair Value Option (FVO) • No prudential filter, but… • Supervisory Guidance on use of FVO by banks • Guidelines and recommended practices address: • Sound risk management and control processes for banks that utilise the FVO; • Supervisory consideration of banks’ use of the FVO in the context of evaluating the adequacy of risk management and regulatory capital • Approach to FVO needs to be set in context of a supervisor’s overall strategy towards an institution

12. Interaction of IFRS with Basel 2 • Most significant issue is the relationship between accounting loan loss provisions, which under IAS 39 are based on an incurred loss model, and the Basel 2 concept of expected loss • This is discussed in draft Basel paper on ‘Sound credit risk assessment and valuation for loans’ • Commonality of methodologies and data for credit risk assessment, accounting and capital adequacy purposes • Nonetheless, accounting and Basel 2 numbers may differ

13. Disclosure requirements • Enhanced transparency and its contribution to market discipline has been a major theme in prudential regulation, and accounting, in recent years • Prudential response: Pillar 3 of Basel 2 • Accounting response: IFRS 7 – Financial Instruments Disclosures

14. Relationship between Pillar 3 and IFRS 7 • May have different scope • Audit assurance probably higher for IFRS disclosures • Pillar 3 emphasises credit risk model embedded within Basel 2, and in some other respects is more prescriptive • So Pillar 3 and IFRS are complementary