Some years ago, when he was chief risk management officer of Barclays Bank, Alan Brown suggested that commitment to financial staying power assumes that the bank’s management worries about exposure. Also, that the whole organiza- tion will be risk-prudent not just once in a while, but every day. Traders, invest- ment specialists, loans officers, and other professionals cannot allow themselves
‘to be a little cavalier at the end of the day’.
Neither is past experience sufficient in detecting new and rapidly changing types of risk. Even if managers and professionals are very prudent with the exposures they assume, the market may move against their best hypotheses, and this like- lihood brings into the picture the duties of two people who will be required to find a solution, without any loss of time:
● The treasurer, who must make available required liquid assets, and
● The chief risk management officer who, with his people, must exercise damage control.
Neither of these executives can afford to take a fire brigade approach. Solutions must be experimented with, properly tested, and holistic. A few years ago, a study by the Bank for International Settlements (BIS) underlined that many firms are increasingly seeking to take a consolidated and enterprise-wide view of risk.3 This, BIS says, is welcome but difficult because:
● The underlying time horizon associated with different risks is variable.
For instance, market risk must be measured daily, while credit risk is usually addressed yearly, and operational risk can be longer term.
● The correlation between different risk types may be very difficult to measure.
Yet, in spite of that, the credit institution must aggregate these separate metrics of risk into one comprehensive number, or a pattern, if the target is aggregate exposure and its control. And:
● There are inherent difficulties in developing precise estimates of benefits from diversification.
Precisely because of these difficulties, integrative solutions are still in their early stages. The reasons identified in these three bullet points require that the bank must have enough liquidity to face its developing exposure(s), with every type of risk taken into account.
Theoretically, this is doable, provided we test our hypotheses, control the mod- els we are using, and are sure about the data we employ. Practically, the three issues just raised are ifs. The computation of economic capital has the charac- teristics of an art, rather than of a science.
This is precisely the reason why, in modern banking, we think and talk in terms of levels of confidence. Exposure estimates must be covered at a high level of confidence by appropriate liquidity in order to confront financial stress. The accounting system being used adds more than a grain of salt to the computation of cash equivalent resources, which needs to be done in order to assure the bank has respectability capital.
With IFRS, as with US GAAP, at origination and maturity of an instrument, fair value and book value have a comparable effect on the bank’s financial state- ments, but for the period in between, fair value will result in more volatility. Is this good or is it bad? Those who say it is bad, don’t realize that:
● While the accruals method provides less volatile numbers,
● This happens because risk is uncoupledfrom the real value of the instru- ments, which must be liquidated to provide liquidity.
This is precisely why the reaction of insurance companies to IFRS, which we studied in the case study in Chapter 2, is irrational. Failure to show embedded volatility in financial accounts is like lying to oneself, which should never be the case. Moreover, the volatility of the instruments in the bank’s portfolio is not lim- ited to their absolute value, but also includes sign reversal. Derivatives provide an example.
● When a contract is in the money, it is written in the assets side of the bal- ance sheet.
● But when, after the market changes, it is out of the money, it moves to the liabilities side of the balance sheet.
As we have seen in Chapter 2, balance sheet accounting was developed by Luca Paciolo in 1494. But more than five centuries down the line, Paciolo’s pace- setting concept does not hold as well as it used to. At the time of the great mas- ter, there were no complex and highly price-sensitive financial instruments of the type we have (in great abundance) today.
By all evidence, the first truly important issue to affect established balance sheet structures has been the fact that newer and newer derivative financial
instruments do not fit so neatly in the assets or liabilities two-way classification because:
● They possess aspects of both, and
● Over time, as the market shifts, they change their position: from assets to liabilities and vice versa.
Even when they find themselves a pigeonhole, some entries may not be there for long, because they are volatile. While this becomes transparent by marking to market, what the reader should understand is that:
● A fact, and
● Reporting on that fact
are not the same thing. What IFRS does is the reporting part. The ‘fact’ is the derivatives positions deliberately taken by banks, insurance companies, and other entities. Fair value accounting can lead to additional volatility in the B/S and profit and loss statement, over the lifetime of these instruments, only because such instruments happen to be volatile.
This is easily illustrated by looking at the balance sheet of a bank in the case of an external interest rate shock. A very important paper has been pub- lished by the European Central Bank, with a couple of balance sheet assump- tions such as (i) no hedging and (ii) a maximum maturity of instruments of ten years. In the absence of an observable or relevant market price, this article states, the fair value of bonds and loans can be approximated by calculating the net present value of their expected cash flows. Such calculation consists of:
● Discounting the cash flows of the particular instrument over the remaining lifetime
● Using a discount rate that reflects the risk-free rate, plus a risk premium.
The effect of an interest rate shock on the fair value of the instruments can, then, be simulated by changing the discount rate.4Ifthey were priced correctly, at orig- ination, the computed value of these instruments will normally be equal to their nominal value. However, as market conditions change, the computed value will also change. It will:
● Decrease if interest rates rise, and
● Increase if interest rates fall.
In either case it will no longer be equal to the nominal value. Under IFRS, a pos- itive change will be recognized in the bank’s income statement as a profit. Under the accruals accounting the portfolio would remain at its earlier book value equal to the nominal value. On the other hand, if this were a leveraged derivative instrument, its value could well become negative. In that case rather than being written on the assets side of the balance sheet, it would belong to the liabilities side – defying and reversing its earlier B/S classification.