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International Accounting Standards: The New Rules on Banks’ Credit Losses

International Accounting Standards: The New Rules on Banks’ Credit Losses

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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

financial statements:




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.



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

(chapter 9).

Theoretically, but only theoretically, the banking union might help

make the European banking industry more stable. This could have a



Banking union



Planned reform

of Euroland’s

financial architecture



Single Supervisory




Single Resolution


Harmonized but not

shared deposit



Asset Quality Review

Stress tests

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.



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

of banks.

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

are in.

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

worldwide perspective.



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

Retained earnings








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:





History, and


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

for losses.

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



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

become believable.

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

investors’ exposure.

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

decision power.

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

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