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IFRS and Basel 2

Ian MichaelAccounting and Auditing Policy Department

Financial Services Authority

Contact: ian.michael@fsa.gov.uk

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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

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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

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EU Experience

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

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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

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Interaction of IFRS with existing regulatory rules

• Definition of regulatory capital

• ‘Prudential filters’

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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

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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

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Prudential filters (2)

• Available – for – sale instruments

– loans

– debt securities

– equities

• Own – use and investment properties

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Two important areas of difference between prudential and accounting treatments

• Securitisations

• Netting

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The Fair Value Option (FVO)

• No prudential filter, but…

• Supervisory Guidance on use of FVO by banks

• Guidelines and recommended practices address:(a) Sound risk management and control processes for

banks that utilise the FVO;(b) 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

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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

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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

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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