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International Accounting Standards: The New Rules on Banks’ Credit Losses
THE HYDRA OF FINANCIAL EXPOSURE
the lender must register further a new write-down. That’s fairly similar to the way the US accounting standard developed by the Financial
Accounting Standards Board (FASB) is working.16
Some experts also say that IFRS 9 can be expected to increase loan-loss
provisions, forcing a few banks to comply with stricter capital requirements. Others are of the opinion that, in the long run, banks will try to
twist the standard to their profit since it provides them with a broader
base to decide when a loan is looking shaky enough to register an expected
The truth lies between this thesis and its antithesis. Indeed IFRS 9
changes the impairment model for how banks recognize losses. They will
have to recognize not only credit losses that have occurred but also losses
that are expected to occur. This will be done through projections, which
are largely guesstimates. IFRS 9 also features three other main elements:
Classification and measurement,
Hedge accounting, and
How an entity’s own credit risk is recognized.
It is fair enough to guess that the impact of the accounting standard
changes will be wide because IFRS is used by listed companies in over
100 countries. Concerns about impairment are spreading and banks will
find it more difficult to overstate profits upfront as they will have to make
prudent provisions against expected losses.
This approach calls for a significantly greater amount of judgment by
senior management. Along with it comes the responsibility for establishing and maintaining an adequate system of internal control over financial
reporting, including the safeguarding of assets. The structure of analysis
must provide reasonable assurance regarding the preparation of reliable
Supported by written policies and procedures,
Containing self-monitoring mechanisms and
Being regularly audited by the internal audit function.
Appropriate action must also be taken, by senior management, to correct deficiencies as they are identified, controlling the possibility of circumvention, overriding of ethical practices, and other misdeeds. Most
important is a dependable assurance regarding the reliability of estimates
and calculation of provisions, in compliance with IFRS 9 rules.
Notice that while the accounting standards worked out by the FASB
and IASB are rather similar, the one is not a copy of the other. One of
their main differences is how far companies should look forward when
they make provisions for losses. The FASB standard (which is still in
the works) is likely to ask that companies make provisions over the
lifetime of a loan. On the other hand, both standards are likely to provide better transparency on credit risk even if they introduce greater
This creates a challenge for banks, auditors, and regulators. Credit
institutions could end up having different valuations of collateral and
different treatments of trigger events likely to result in an expected loss.
There is also a potential for greater variability and in all likelihood adjustments will have to be made to the new accounting standards as experience is gained with their implementation.
Changes can be as well expected with accounting rules pertaining to
operational risk, particularly related to special purpose vehicles (SPVs)
and helicopter fines. Already after the 2008 descent to the abyss, regulatory rules have aimed to bring back more debt on balance sheets for
financial reporting purposes, making the mother company’s SPV dealings more transparent.
The need for change was dramatized a few years prior to the banks’
financial earthquake with Enron’s collapse, because it raised questions
about the company’s complex web of off-balance sheet deals and the way
these were recorded. Still with hindsight, it can be said that nothing really
dramatic happened in financial reporting—even if (at that time) nearly
60 percent of those surveyed by S&P had been concerned that new rules
would restrict the future growth of the securitization market.
The domain where there was a significant change was the supervision of certified public accountants (CPAs), in spite of intense lobbying
against the toughening of rules. (From 1997 to 2002, in five short years,
the accounting industry spent a rumored $39 million on lobbying in
Washington.) The CPA’s area of responsibility has been enlarged to cover
areas that earlier on did not fall under their remit.
Lobbying always works best on issues that are little noticed by the public. Therefore, they have few political repercussions for lawmakers. When
corporate responsibility becomes a highly visible issue, the lobbyists’
cause becomes tough. That’s how one should look at the creation of an
independent oversight board in Washington, DC to govern the accounting industry with the power to:
Set ethics standards,
Investigate malfeasance, and
Impose penalties on wrongdoers.
THE HYDRA OF FINANCIAL EXPOSURE
This supervisory board replaced a system of self-regulation by
accounting firms, exercised through their trade association. It also helped
to curb conflicts of interest by limiting the kinds of consulting services
accounting firms can provide for their audit clients. But the government
did not prosecute corporate malefactors, and till that happens the threat
of tougher sanctions is not a compelling deterrent.
The European Banking Union:
An Exercise in Abstraction
1. Banking Union and the Financial Cycle
The 2007–2008 economic and financial crisis exposed significant weaknesses in the European banking industry. The immediate reaction was
the rush by sovereigns to refill the treasuries of self-wounded banks with
taxpayer money. The concept of a banking union was mooted but did not
get unanimous approval.
To give to the banking union a sense of legitimation and of substance,
the ECB took upon itself the mission of directly supervising 130 of the most
important banks in Euroland, while the European Stability Mechanism
(ESM) was put to task to provide the funds along with a bail-in procedure
involving shareholders and bondholders. As shown in Figure 10.1, the
planned banking union has set in motion:
A fundamental reform of the European financial architecture,
A Single Supervisory Mechanism (SSM),
A Single Resolution Mechanism (SRM), and
A harmonized deposit insurance scheme.
The objective of all this has been to strengthen financial stability in
Euroland, taking better account of the creditworthiness of financial institutions, both individually and in regard to cross-border banking activities. Another goal is to loosen the doom loop between financial industry
debt and sovereign debt. This does not look achievable, judging by the
recent Banco Espirito Santo (unwarranted) rescue through public money
Theoretically, but only theoretically, the banking union might help
make the European banking industry more stable. This could have a
Harmonized but not
Asset Quality Review
Figure 10.1 Banking union and supervisory assessment of exposure of
Euroland’s banking industry.
better chance if it is supported by further European integration in the
fields of economic policy and fiscal policy, which is not the order of the
day. Even the notion that the ECB will be able to directly supervise significant banks in the participating countries with support from the national
competent authorities (NCAs) in day-to-day duties of off-site supervision
and on-site inspection is questionable.
Again, in theory, the ongoing supervisory tasks will be carried out by
joint supervisory teams (JSTs) comprising supervisors from the ECB and
the NCAs (No mention is being made in all these decisions to linguistic
barriers and the close connection between NCAs and the big local banks).
The supervision of less-significant credit institutions will (for the most
part) remain the responsibility of the NCAs.
It is supposed, that with this set-up, the process of prudential banking supervision will become increasingly harmonized. A comprehensive
assessment of big banks’ balance sheets is projected to be carried out with
the aim of enhancing the transparency of the institutions’ exposure, as
well as strengthening public confidence. It is too early to have a documented opinion on this matter.
THE EUROPEAN BANKING UNION
These statements sound rather pessimistic. They are so. The prerequisites for making the planned banking union a success story are
many, and they are not necessarily fulfilled. A most basic prerequisite is
a nearly unlimited amount of money. The €500 billion ($675 billion) of
the leveraged ESM (which is also supposed to support member states in
need) will be eaten up for breakfast. The public debts of Italy and France
are nearly €5 trillion ($6.75 trillion); other Euroland member states,
too, are in deep debt. Over and above that comes the capital shortfall
Just as fundamental, but difficult to realize, is breaking the vicious
cycle between banks in financial difficulties and highly indebted governments using public funds to rescue banks. To this has been recently added
the further instability of unwarranted huge penalties (chapter 7). Taken
together, the eleventh-hour salvage by taxpayer money, sovereign lending
by banks, and unprecedented penalties are defeating the main objective
of the European banking union to:
Restore confidence in the banking industry
Strengthen financial market integration, and
Promote lending to the real economy, a crucial input to elusive
The list of themes that have a rather doubtful existence is long, and
this leaves the planned banking union as an exercise in abstraction. There
are, however, two exceptions to this argument that are worth bringing to
the reader’s attention because of their potential impact on the main theme
of this book.
Euroland’s banking union is the first exercise in financial corporatism that will, in all likelihood, characterize the financial cycle we
The single resolution mechanism outlines how troubled banks should
be wound down in the future. Whether this will happen with or without using taxpayers’ money is something that time will tell. At this stage,
there is no visibility about its timing and structure. A similar statement is
valid regarding the way the single supervisory mechanism will work out
in practice—not only in the short term but also in the medium to longer
term, if it survives that long.
Euroland’s banking union is a milestone in deglobalization, its focus
being regionalization embracing 18 economies, in contrast to a
The SSM, SRM, AQR, stress tests, harmonized deposit guarantees,
and contemplated reform of Euroland’s financial architecture matter
both to the institutions affected and to the bureaucrats with shiny new
jobs ion supervision. Among them they create a common backstop for
failing banks (not for the economy) whose economic impact will be felt
on a regional basis.
Its effects will become more apparent when the emphasis shifts from
policy choices to their consequences. If the banking union fails (which is
a possibility) its memory will be part of the dust of history. If it succeeds,
it will eventually oblige the politicians to settle. An effective cross-border
settlement will however require an adjustment strategy of a historically
unprecedented scale, and most likely this will find imitators in regionalization in other parts of the world.
A great deal of the difference between success and failure will be due
to politics, and the prospects are not that good. The next most important factor is the effectiveness and transparency of the steps taken toward
making the banking union’s mechanism capable of delivering results.
Have no illusion on this matter. If it is honest the review of the 130 bigger (and/or systemically important) banks of Euroland has to be harsh—
which is not politically acceptable under present conditions. Yet only a
detailed, honest, and harsh evaluation can provide clarity about the status
of European banks.
If (and this is a big IF) appropriate follow-up actions are taken,
Then this exercise could restore confidence in the banking
At present, without any hard evidence available, it would be superficial
to assess the likely outcome of the banking union effort. Even for the more
concrete part of it, the stress test, it is not known what its results will be or
if they will be transparent. Nevertheless, it is reasonable to expect some
banks to fail the test. Will the ECB want to talk about problem banks in
its supervision portfolio? Issues are more likely to arise for banks with
risky loans, derivatives trades, and questionable investments, where no
action has been taken on a national level to right the balance.
For instance, Italian and French banks, which could also face headwinds from the negative macroeconomic situation in their countries of
origin. Moreover all Euroland banks will more or less have to confront
and implement significant changes to their policies, including:
Changes in deductions
THE EUROPEAN BANKING UNION
Hybrid capital changes
Preference share issuance
Preference shares redemption
Convertible bonds issuance
Common stock issuance
Appropriate attention must also be paid to the cost of acquiring more
stable finances. Since convertible bonds and preferred shares will be in
the frontline in case of financial adversities, they will have to significantly
increase their interest rate to compensate investors for the risk. Higher
rates cut into profits and it is not unreasonable to expect that banks will
try to game the banking union system, most likely with support from
their national regulators.
2. Reservations about the Banking Union and Its Impact
Those who welcomed Euroland’s banking union, essentially its champions, say that though still an imperfect construct it has been a breakthrough. The negotiations took more than two years and it has not been at
all easy to convince governments, national competent authorities, central
bankers, and regulators to surrender their sovereignty, at least on paper.
Yet, it has now happened.
Critics answer, and even some of the banking union’s champions
admit, that what is available today is closer to the “timber-framed” first
phase described by Wolfgang Schäuble, Germany’s finance minister. It is
not at all sure that the fledgling institutions of the union, briefly described
in section 1, will live up to their billing. Important flaws remain in the
design of Euroland’s banking union, not least the presence of banking
structures that are incompatible with one another in terms of their:
The guiding principle behind the banking union’s mechanism is liability and its handling by means other than throwing taxpayer money at
it. In the opinion of those who like neither the use of taxpayer money nor
the bail-in1 concept, in a market economy banks must be allowed to fail—
and when they fail they should exit the market. Wounded banks that can
find private money to repair their balance sheets should face restructuring. Deus ex machina should not be pulling them up from under.
Politicians and economists who favor bail-ins answer that bank bankruptcies are endangering financial stability and the use of taxpayers’
money has a purpose. In their opinion, the channel of sovereign support
should remain open, even if it is envisaged that the banks’ owners and
creditors must bear an appropriate share of the losses. Public funds, this
argument goes, has to be used as a last resort.
Indeed, a good deal of the banking union’s credibility revolves around
these three words “a last resort,” as well as around the criteria and timing
of bank bailouts. The failures of Espirito Santo, Portugal’s largest bank by
assets (chapter 9), brought plenty of doubt regarding the sense of “a last
resort.” It added an element of confusion when Portugal’s central bank
announced its plan to protect creditors of Banco Espirito Santo.
The reaction by the banking union pros was that there should be
no more taxpayer-funded rescues, but in the case of Espirito Santo
they agreed to the use of public money to bail out depositors and
senior bondholders, at the same time raising the question: Do regulators want to end bailouts or only talk about abstract ideas that are not
Contrary to the milder position taken by the pros, critics opine that
whether or not there is a banking union, politicians and regulators still
subscribe to the view that big bank bailouts are inevitable—or, worst,
there is plenty of conflict of interest in the system. That would explain the
slow progress toward making big financial institutions:
Simplify their legal structures,
Trim their dubious “assets,”
Control their risks, and
Become less intertwined with one another through cross-holdings.
The major Espirito Santo creditors were not the kind to sit quietly
and hope to recover the big money they lost by way of the Portuguese
bank’s restructuring. This has not been true of all creditors. While not
quite a bail-in, the big bank’s woes left junior bondholders on the hook
Some subordinated Espirito Santo bonds traded at 30 cents on the
euro, reflecting the precarious position of the Portuguese bank. In contrast, senior bonds recovered their losses early enough, after benefiting
from the billions contributed by the Portuguese taxpayer to the defunct
institution’s Novo Banco, recapitalized with a €4.9 billion state aid.
Theoretically, but only theoretically, when eventually the banking
union gets in full swing that course of events might not be possible. From
2016, if at all applied, tougher bail-in rules will bring to the task senior
THE EUROPEAN BANKING UNION
creditors. But will be enough to prevent taxpayers having to foot the bill
for failing banks? What about the notion of “a last resort”?
Regulations in other countries, for instance, the Dodd-Frank Act in
the US, mandate that large banks must eventually be bankruptcy-ready.
If their living wills are deficient, the authorities have to use the tools at
their disposal to make them safe through restructuring, breakup, or closing down. But the authorities have not yet taken such steps so that they
Banking union rules say that the government of a bank’s home country should not pour public money into its treasury. Neither is direct
recapitalization of banks by other member states of Euroland appropriate. Leaving aside the fact that the ESM billions are “other member states’” money, 2 what will happen if a Euroland government—like
Portugal—proceeds with a direct public money rejection?
There are hundreds of banks in Euroland with what is called the
“unquantifiable risk” Espirito Santo model. Portuguese regulators have
been all over this bank and yet they found nothing till the blow-up.
According to unconfirmed reports no one really knew what they were
pricing in terms of dubious instruments and what the extent of the bank’s
exposure was. Sounds familiar? Indeed it is so.
The way Oliver Burrows, a senior banking industry analyst at
Rabobank, put it: “If you’re a regulator the answer is not to drop a nuclear
bomb [on creditors] but to find a diplomatic solution.”3 That’s the other
side of the equation that the banking union has not even touched. Yet it
is a basic issue that will lead the hand of both national regulators and the
decision-makers at the ECB.
Concomitant to this is the fact that neither bail-in nor reputational
risk has been priced into the curve of rates paid by banks for their debt.
When either or both take place, they will surely upset the markets. This is
particularly true as 2014 saw the issuance of bumper levels of riskier debt,
over $70 billion of it with interest rates at about the level of 2005–2007.
The very low interest rate bubble is growing, and so is the banks’ and
In addition, because the ECB, which is the common central bank of a
currency area, will probably act as one of the lenders of last resort, it is
necessary to ensure that financial intermediaries of the different member countries abide by a common set of rules and regulations. Otherwise,
moral hazard issues will:
Undermine the entire new banking architecture,
Thwart fair competition, and
Lead to frictions among Euroland’s member states.
These, too, are issues that have not been appropriately studied in the
negotiations that led to the banking union text. Such negotiations were
mainly centered around “who pays” and “who gains.” Judging from what
became known, they did not examine future operational problems and
obstacles by way of a simulated environment with many unknowns. Yet,
it would have been the rational thing to do given that the whole effort was
the first of its kind.
By contrast, a more consistent type of work has been done in connection with the supervisory board and the mediation panel. In regard
to the former the members of the supervisory board are the chairman,
vice chairman, four representatives of the European Central Bank, and
one representative of the national competent authority. This supervisory
board will be supported by a steering committee chosen from among its
members. The latter will have no decision-making powers. It’s planned
that its composition will ensure a fair balance and rotation between
For its part, the European Central Bank will create a mediation panel
to resolve differences of views expressed by competent authorities of
Euroland member states. For instance, in connection with an objection
by the ECB Governing Council to a draft decision by the Supervisory
Board. This is not necessarily the best approach. As one of the parties, the
ECB cannot also be the judge.
Still the banking union resolution further empowers the ECB to adopt
a regulation setting up the mediation panel and its rules of procedure.
The current accord envisages that members of the mediation panel will
be chosen by the participating member states. That choice will be limited
among the members of the supervisory board and the ECB Governing
Council. The vice chairman of the supervisory board will chair the mediation panel meetings but without voting rights.
A built-in downside is the risk that the mediation panel will become
a paper tiger, since according to its status its opinions are not binding on
the supervisory board and the ECB Governing Council. On the contrary,
by virtue of its status as the ECB Governing Council supreme decisionmaking body it has the ultimate responsibility—hence, the sole decisionmaking competence. This amounts to an awfully large concentration of
3. Banking Union Weaknesses Because of
Profligate Member States
In November 2012, when the discussions about a banking union were
more or less in the clouds, the demands posed by Euroland’s profligate