Pilgrim’s progress – the road to fairness 

The ISAB’s desire to implement fair value accounting for financial instruments has faced controversy and complaint and seemed likely to be watered down when it was drawn into the realms of EU politics. Now however, fairness is back and thanks to the IASB’s background efforts it doesn’t look much different. Rolf Stromsoe charts the progress of the fair value option. After months as the ultimate accounting hot potato, the excitement surrounding the IASB’s fair value option for financial instruments has finally subsided. On 16 June an amendment to IAS 39 was published restricting the circumstances in which companies can measure financial instruments at fair value. The amendment is a stop-gap measure and it fails to solve a number of problems with fair value accounting but it has resulted in an uneasy ceasefire in a heated accounting battle. 

Since the IASB’s predecessor body, the International Accounting Standards Committee (IASC) first bravely took on the challenge of composing a standard addressing the accounting for financial instruments 17 years ago, the appropriateness of "fair value" as the basis for measuring financial instruments in the balance sheet has been hotly debated. Fair value is defined by the IASB as "the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s length transaction" which contrasts with the more familiar practice of measuring items on the balance sheet at their historical cost. 

Noble intentions 

In 1988, the IASC began deliberating on its first financial instruments standard. Eight years and two exposure drafts later it concluded, in light of the poor reception the exposure drafts had received, that its initial proposals for a standard covering the measurement of financial instruments should be abandoned. However, interest in the subject was revived in 1997 when the IASC agreed with the International Organisation of Securities Commissions (IOSCO) that it would develop a set of "core" International Accounting Standards that could be endorsed by IOSCO for the purpose of cross-border capital raising and listing in all global markets. Those core standards would include one covering the measurement of financial instruments. Working with the Canadian Accounting Standards Board, the IASC produced a discussion paper in 1997 that proposed measurement of all financial instruments at fair value. This discussion paper was greeted with significant unease and it was clear that full fair value accounting for financial instruments was going to be a hard sell. 

A makeshift solution 

In the meantime, a standard for the recognition and measurement of financial instruments was urgently needed and the IASC looked across the pond to the US, who had the most advanced standards on the subject at the time, and issued the first version of IAS 39 in 1998 based on the FASB’s compromise mixed measurement model. The mixed measurement model, which remains the basis of the current IAS 39, prescribes either historical cost or fair value as the measurement basis for each financial instrument depending primarily on the company’s reason for holding it. The 1998 version was intended to be an interim measure and the IASC did not abandon its belief in fair value. Through the Joint Working Group (JWG) it issued a draft standard in 2000 which again espoused the ideals of fair value measurement and proposed fair valuation of virtually all financial instruments. Again, stakeholder’s reaction prevented the JWG’s proposals being progressed. 

The fair value option

 In July 2001 the IASB announced that it would undertake a project to make limited improvements to IAS 39 without reconsidering the fundamentals. Among the changes that were published in December 2003 resulting from the "Improvements Project" was the inclusion of an option to measure any financial instrument at fair value through profit and loss. The board recognised that the mixed measurement model could result in "accounting mismatches" when related items were measured on different basis. Since matching the measurement basis by allowing measurement of trading instruments and derivatives at cost was clearly off the table, the board concluded that a company should be given the option of matching the measurement basis by measuring the other side of the relationship at fair value through profit and loss. The fair value option was also useful in simplifying the accounting for embedded derivatives and a few other tricky accounting situations IAS 39 had thrown up. The board reasoned that since fair value is its preferred measure for financial instruments, if companies want to measure items at fair value that they aren’t required to shouldn’t they be allowed to? The board acknowledged that determining the fair value of financial instruments can be difficult and unreliable, especially when no active market for them exists but broadly concluded that the benefits outweighed the measurement difficulties. The fair value option would not require companies to measure more financial instruments at fair value than previously but would afford them greater flexibility in selecting the most appropriate measurement basis. 

Europe 

Whilst controversial, the introduction of the fair value option in 2003 was widely welcomed by companies then reporting under IAS and other stakeholders. Early experiences showed it to be useful in the circumstances envisaged by the Board and very few companies appeared to have any desire to abuse it. 

However, as the adoption of IFRS in Europe approached, the fair value option came under the spotlight of the European Commission who voiced concerns that it might be used inappropriately. These concerns were echoed by other important stakeholders, notably the Basel committee and the European Central Bank. In response to these concerns, the Board reluctantly issued an exposure draft of proposed amendments in March 2004 that severely restricted the situations in which companies could apply the fair value option. The proposed amendments were complex and the vast majority of commentators felt that they were a step backward. The board received 116 comment letters on the proposals the staff analysis of which showed that only 15% of respondents agreed with restricting the fair value option, and none of those agreed with substantially all the proposals in the exposure draft. The proposals were regarded as unworkable and the political interference from which they stemmed was widely criticised. In response to the comments received, the IASB withdrew the proposals. 

The carve-out 

In December 2004, with adoption of IAS 39 in Europe intended for 1 January 2005, the IASB was in a difficult position and pressure was mounting. Europe would not accept the unrestricted fair value option and the vast majority of other stakeholders had rejected outright its proposals to restrict the fair value option. The saga reached its low point when the European Commission lost patience with the situation and adopted its own version of IAS 39, "carving-out" the offending fair value option (as well as some hedge accounting rules). 

European companies, adopting IAS 39 on 1 January 2005 faced the unenviable prospect of being forced to adopt a watered-down version of IAS 39. Instead of being able to state compliance with an internationally harmonised set of accounting standards, European companies would report in terms of "IFRS as endorsed by the EU". First time adopters, (especially banks who are most likely to use the fair value option) complained that the vacillation of the standard setters and politicians was making the already difficult transition to IFRS untenable. The fair value option was becoming a political and difficult issue and the credibility of the key players was at risk. 

A new approach

 Early in 2005, realising the gravity of the situation and keen to find an eleventh hour solution, the IASB proposed a "possible new approach" to the fair value option. In February 2005 Sir David Tweedie announced that there had been a "very useful" meeting with representatives of the European Central Bank and the Basel Committee and their views had been taken into account in the proposals that were to be discussed at a series of round table discussions. The round tables were open to the public to ensure that all stakeholders were given the opportunity to contribute and to address growing background noise that the Board was not consultative enough. 

In many ways, the "new approach" was not very different from the March 2004 proposed amendments to restrict the fair value option that had been roundly rejected by respondents to the exposure draft. However this time, the board felt that it managed to garner enough support for the proposal to progress it into the amendment published on 16 June 2005. The European Commission was happy and the impasse had been broken. 

The restricted fair value option 

The new amendment restricts the option to carry any financial instrument at fair value through profit and loss to situations in which certain conditions are met. In brief the conditions are: where fair value designation eliminates or significantly reduces an accounting mismatch, where a group of assets, liabilities or both are managed and their performance is evaluated on a fair value basis in accordance with a documented risk management or investment strategy, and when an instrument contains an embedded derivative that meets particular conditions. The conditions are closely aligned to the uses the IASB had initially envisaged the fair value option being put to. The amendment becomes effective on 1 January 2006 and has detailed and complex transition rules. 

It has been a big year for accounting. Fair value accounting for financial instruments became a hot topic and accounting was drawn into the world of European politics. At the end of it we have been left with an even more complex IAS 39 but importantly we are closer to a single agreed IAS 39 for all IFRS reporters (the hedging carve-out remains). The IASB has set up a Financial Instruments Working Group to take up the mantle of improving on the status quo. The FIWG has been mandated to take a fresh look at IAS 39 with a view to examining and questioning the fundamentals of the standard. Its role is to assist in improving, simplifying and ultimately replacing IAS 39 and to examine broader questions regarding the application and extent of fair value accounting. The Group’s goals are ambitious and its focus is long term so the current standard will be with us for a while yet.  
Article by Rolf Stromsoe 

Risky business? Creating value in a volatile world 

A Deloitte study reveals that UK share prices are particularly prone to value loss due to market volatility and that they are more susceptible to the negative impact of extreme external events than shares in other markets. Research Director Chris Gentle says it’s time to ask "why?" and to acknowledge that concentrating on value creation – regardless of external blows – is the way to bounce back faster and further. 

The tragic events witnessed in the southern USA continue to grab the headlines. Hurricanes Rita and Katrina have had a huge human and business impact. They provide a microcosm of the huge variety and types of unpredictable, one-off risks financial institutions may face today and may increasingly face in the future. The resilience of companies share price to the impact of major events is something executives need to better understand – by continually refreshing risk management and value enhancing strategies. 

Investors and executives share a mutual desire for the success of their company, but they also harbour a common fear: a significant drop in share price. Unfortunately, unlike many concerns, this phobia is grounded in reality. Steep market drops affect a significant percentage of companies, encumbering them with negative repercussions that can last for years. 

Indeed, over the last decade, almost half of the 1000 largest global companies suffered declines in share prices of more than 20 percent in a one-month period, relative to the Morgan Stanley Capital International (MSCI) World Index. By the end of 2003, around a fifth of these companies had still not recovered their lost market value. Another one-quarter took more than a year for their share prices to recover. 

Although each of these companies experienced unique circumstances that contributed to their loss of value, there are several common underlying risk factors that resulted in a negative effect on value. 

The process of value creation is central to building a dynamic and competitive economy. Three major trends tend to influence the value creation process. First, volatile market conditions have had a polarising effect on the ability of companies to create value. Second, there is a stark difference between the strategies of value creators and those companies prone to destroying value. Third, market liquidity tends not to strict growth. For instance, the liquidity of UK markets has grown in absolute terms over the last decade. Further, a handful of UK companies have gone literally from zero to hero, from FTSE 250 to the upper echelons of the global 100 – witness the rise of The Royal Bank of Scotland Group and Vodafone. 

Further analysis of the response of UK listed companies to one-off events is particularly instructive for financial institutions to feed into running their own businesses: 

  1. Foundations for success based on relentless value creation aspirations. The last ten years have proved extremely turbulent for UK listed corporates. The lesson for their managers is that value is and will always be at risk from unexpected, unavoidable (internal and external) events. However, value can still be created in this volatile environment and it is critical to access a value creating, rather than value destroying spiral. We found from our analysis of UK listed companies compared with a global basket of listed stocks between 1995 and 2005, that the most value creating, resilient UK companies focus on long-term risk management strategies which build material value for their stakeholders, e.g. brand, reputation, unique organisational practices and strategies. These value creating corporates go on not only to recover any value lost, but also to add further value. By contrast, value destroyers, the least resilient UK companies, focus on short-term tactics that may shield themselves from outside risks, but do not build long term value for their stakeholders. They lack the capability to build and manage the resiliencecreating intangible assets, such as unique business practices, strong brand and robust information flows. In fact 80 percent of value destroyers have never fully recovered their lost value. Our research shows a contrast between value creators and value destroyers that could not be starker. Future success of UK corporates rests on careful integration and equal treatment of tangible and intangible assets within a value orientated strategy. 
  2. UK markets have been more volatile than global markets over the last ten years. UK-listed businesses in the FTSE 100 and FTSE 250 experienced more volatility than their counterparts in the MSCI World Index. However, there is an intrinsic volatility for smaller listed companies which could raise governance issues. This makes long-term communication strategies with stakeholders – investors, employees and suppliers – particularly important. 
  3. It takes a long time for firms to recover, if they ever do. The value losses for UK companies were generally greater than their international counterparts. British equities were also less likely to recover their value within a year. Even more important, research found that one quarter of UK firms that suffered a one-off shock have yet to recover their lost value – which helps explain why life at the top has become increasingly perilous for Britain’s executives. 
  4. Companies in the FTSE 250 index are most vulnerable. Our research shows that smaller listed UK corporates have experienced the greatest volatility. Over the past ten years, nearly half of FTSE 250 companies experienced one or more events where they lost at least a third of their value – compared to roughly a quarter of the FTSE 100 companies. As a consequence, some FTSE 250 corporates may find themselves sucked into the vicious spiral of dependency on short-term share price movements – a dependency that makes them overly risk averse, and ultimately perpetuates their volatility. This may appear an odd discussion for those who are familiar with the UK market. Recently, the FTSE 250 has hit record levels. This merely emphasises the point that senior executives should rest on their laurels. 

HSBC bouncing back from 1999

HSBC made a quick recovery from the Asian financial crisis, and has delivered strong financial results since 1999 – largely driven by an aggressive acquisition strategy overseas, and by continued strength in the UK. Today, the firm is first in its sector for economic value added. It is also recognised as a good corporate citizen, proudly appearing on the FTSE4Good index. HSBC’s recovery and strength are the direct results of a five year strategy based on "managing for value". The strategy emphasises growth through strategic acquisition and strong financial management, and through intangibles such as innovation, people, customers and ethics. 

In the boardroom 

Running a major business has never been more challenging. Over the last decade, for instance, UK-listed companies endured more volatility than their global counterparts – making it exceedingly difficult to achieve their business goals and deliver sustained performance. Running a FTSE 250 listed corporate in the UK has been even tougher. Not only has the FTSE 250 experienced more volatility; smaller corporates are even less likely to recover their lost value. Overall a quarter of the firms we studied never regained their original value. For most boards, this is an unacceptable result – and is likely to make the position of CEO or CFO tenuous at best. In summary, now is the time for a serious debate around the issue of why value is more at risk for corporates in the face of extreme events. For instance, why is it that UK corporates are more prone to value loss due to market volatility and how do other major markets compare? It is imperative to understand in more detail what best practices can be deployed by listed corporates to ensure that the value creation process becomes less risky in the face of extreme events.  

Putting theory into practice

Over the last ten years, Royal Bank of Scotland (RBS) has successfully negotiated every major market shock. This resilience resulted from the bank’s broad based market strategy, and its diverse collection of revenue streams – particularly from new products and new geographies.

The bank’s value creation strategy has five major elements:

  • diversifying talent. Making a conscious effort to blend in-house talent with an influx of expertise from other industries;
  • sharing information and clarifying roles;
  • building the capabilities and agility to anticipate and respond to critical events and market shocks;
  • diversifying investors. Not becoming too dependent on one type of investor. Communicating to employees;
  • aligning behaviour with strategy. (A recent survey by the bank showed that 85 percent of its employees clearly understood the overall business objectives); and
  • diversifying deals. Executing deals wherever good opportunities arise. Through these intangibles – and a diversified growth strategy – RBS has shaped itself into the world’s fifth largest bank.
    Article by Chris Gentle 

Towards a "credit treasury"

A host of new factors – both regulatory and technological – are militating towards banks taking a new approach to loan pricing. Key for success is a consistent and integrated data model. Deloitte’s Rolf van den Heever argues that the trend for intermediation is just the first step towards an integrated "credit treasury".

Background

In recent years methodologies behind the pricing of illiquid loans has become more sophisticated. Banks’ attitudes shifted from relying solely on loan officers’ judgement to set the right margin towards providing them with tools that determine the risk adjusted margin they should require at a minimum subject to business considerations. The technology is most crucial to success. Lower margins than appropriate according to the risk features will dilute capital returns and at worst attract bad business and conversely requiring higher margins than the market will cost potentially good business volume. In contrast to highly liquid, arbitrage-free markets, in which a trader’s success can be measured instantly, perils in illiquid markets are more persistent and less transparent. Banks may discover that they have priced risk incorrectly only when it is too late.

The new regulatory requirements challenge banks from different perspectives. Credit risk needs to be measured more accurately, managed on a timely basis and capitalised on a risk adjusted basis (Basel II); deferred gains and losses on the loan portfolio become visible through incorporation of fair value reporting (IFRS) principles; and finally, senior management needs to be more focused on compliance. While Basel II yields a proper basis of data, IFRS and compliance serve as additional external incentives to better credit portfolio management.

Current challenges

Notwithstanding these incentives, banks should always pursue own business goals when improving procedures. The main pressure on loan pricing technology will come from a continuously evolving fungibility of loan portfolios. Due to decreasing costs smaller firms will be able to issue bonds instead of approaching their bank for a loan; entire loan portfolios are sold through securitisation; trading platforms for loans are, however, far from perfect.

Hence, the core question is about the right benchmark spread for a loan when originated. Apart from observing what competitors offer banks usually perform some kind of cost pricing where the margin is constructed from cost, risk and profit contributions. However, with increasing fungibility this approach needs to be challenged by considering bond spreads and valuation of securitisation, that is to say comparing own assessment of risk with market consistent assessment of risk.

Construction Price

It is good practice to support loan departments by a proper loan pricing technology. Front office employees should be able to assess instantly the respective hurdle margin when recording a facility and its risk features, above which a contract is entirely profitable for the bank. Simplified, the margin can be disaggregated into a servicing margin, the expected loss and the unexpected loss and a profit component. Evidently, the precision of the results and thereby the market proximity is only as good as the underlying model and data.

The three components required are (a) a distinct cost accounting approach, which is able to allocate indirect costs to facilities; (b) a precise measurement of, and prediction model for, exposures (including optionalities), default frequencies and loss rates on defaulted facilities; and (c), both a regulatory capital model and an internal credit portfolio model yielding the marginal contribution to economic capital for the respective facility. A vast literature exists on these topics but three issues are worthwhile to be considered in our context: data, conservatism and idiosyncrasy.

Data

Each component is highly complex in itself. However, key for success is by and large a consistent and integrated data model covering the data capture process, the data base and the data extraction for modelling purposes. Banks adopting good practice have implemented bank-wide data models before Basel II and IFRS hit for six risk and finance departments. Modelling is important as well but can be improved steadily over time; changing data models costs a fortune and their legacy lasts for decades. Banks are well advised to plan data models with foresight and utmost care.

Conservatism

Prediction of EAD, PD and LGD is mainly driven by satisfying capital requirements under Basel II but the particular demand for proving internal usage should not be underestimated: Be prepared that impairment as well as fair value disclosures under IFRS will be cross-checked against these estimations if not already used as main drivers. Apart from the timing – pricing considers cash flows until maturity while Basel focuses on a one year horizon – one danger in applying Basel figures to pricing is conservatism. Supervisors require conservatism and risk controllers often act over-cautiously in order to be on the safe side. Potentially, the margins based on conservative risk assessment harm competitiveness; also under IFRS the principle of prudence is subjugated to the principle of neutrality. To advance internal usage for the purpose of loan pricing neither the data nor the model should be adjusted for conservatism but rather the results themselves (by analogy a point estimator should be accompanied by a confidence interval). This would preserve the applicability of models under Basel II to pricing and accounting thereby exploiting the possible synergies.

Idiosyncrasy

Central to our discussion is, however, to what extent such a cost based pricing is idiosyncratic to a bank. Assuming that all market participants need to cover servicing costs and expected losses, the final decision is whether the remainder of the margin (so-called risk adjusted net return) meets a bank’s minimum requirements for capital returns (apart from truly important cross-selling arguments), i.e. is the RAROC acceptable. Returns could be measured with regard to regulatory capital but many prefer marginal economic capital taking into account diversification and correlation effects. While regulatory capital is more or less comparable among banks, economic capital very much depends on the composition of the bank’s specific portfolio.

Speaking in an economist’s language the bank designed its individual production function including investors’ preferences by taking "their" hurdle rate into account. Because market participants cannot exploit arbitrage opportunities in illiquid markets (no trading is possible in small or medium corporates’ credit spreads let alone short sales and derivatives; transaction costs are high; and mutual trust and personnel relations play still an important though diminishing role), different pricing functions can indeed co-exist, while we would expect markets to fluctuate around long term equilibrium. We may observe customers moving slowly between banks or particular types of customers pooling assets with certain banks. Typically, innovation attracts new customers more quickly and is much better rewarded than improvements to ongoing business like cost cutting. Nevertheless, cost based pricing is the first benchmark and needs to be constructed carefully while taking account of competitive factors.

Bond and securitisation prices to establish market consistent pricing 

Cost based pricing, however, is only a partial view on a general equilibrium. Loan markets compete with bond markets. A treasurer may ask "Why invest in loans when returns on bonds are better?" when capital is allocated across a bank’s profit centres. This demand for internal competition should be answered by translating corporate bond spreads into loan margins.

In all major western currencies sufficient numbers of corporate bonds are traded allowing the derivation of a proper credit spread matrix. Since bonds incur hardly any transaction costs when purchased and are only generally secured by the debtor’s assets, loan margins need to be adjusted by the cost margin and the particular recovery rate in order to achieve an unsecured margin. This is not an easy task especially because bond spreads fluctuate more. However, it is possible and a comparison between average loan margins across loan departments and bond spreads, say over the last quarter, provide valuable information to senior management in order to detect opportunities, less profitable markets and loss drivers.

Securitisation offers new opportunities for active management. Securitisation eliminates the need to avoid new business that leads to high concentration (thereby to high marginal capital and high margin requirements) if it can be sold through a securitisation vehicle to the financial markets. This is not yet standard practice for all firms but if it were, the price of a loan would be determined by the marginal price change of a securitisation (assuming that the linear pricing rule of complete liquid markets does hold in incomplete and illiquid markets). Hence, one might expect pricing models for loans in the future to be linked to the pricing of CDOs, recognising however that the latter product is still developing.

Intermediation

Banking is driving more and more towards pure intermediation. To borrow from the thoughts of Modigliani and Miller: "Why keep risks in the books if investors can decide themselves to purchase credit portfolios or not". Two issues are strategic prerequisites: Excellent securitisation capabilities embedded within an appropriate organisational structure for active credit portfolio management. Looking forward credit portfolio management is not just contained in a loan department nor is it contained in a risk control department; it needs indeed to be a "credit treasury" department acting as an internal risk purchaser and accumulator for its own loan departments on the one hand and an external trader selling own credit portfolio (slices) and managing the macro position by credit derivatives on the other.

Conclusion

Market pressure will force banks more steadily towards pure intermediation. Excellent technology with regard to risk assessment and risk pricing is, and will even more be, a crucial factor for competitive advantage. If not yet on the way, banks should consider an integrated approach to credit portfolio management in which loan pricing is just the first step.
Article by Rolf van den Heever

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