No gambler ever hankered for the feverish delight of the gaming table as much as some banks are doing today in trading among themselves, and with hedge funds,
novel, obscure, and highly risky derivative financial instruments. Only fair value accounting can lift the veil of secrecy surrounding derivatives gains and losses.
IAS 39 and other vital parts of IFRS target the accounting side of the art and sci- ence of risk management. To appreciate that point one should recall there are two sides in the equation of capital and enterprise: the cost of capital, and its exposure to potential loss because of misjudging risk and return. The cost of cap- ital is set by the market; the risk to which capital is confronted is defined by the amount of exposure being assumed.
● A greater volatility indicates higher but also more uncertain return, with its counterpart being the likelihood of higher losses.
● Uncertainty plays an important role in addressing the risk involved in business transactions. With derivatives, risks are generally shifted toward the more uncertain future.
IFRS would not have been worth its salt if it did not contain the needed account- ing tools and methods for mapping uncertainty and risk embedded in inventoried portfolio positions. ‘The growth and complexity of off-balance-sheet activities and the nature of credit, price and settlement risk they entail, should give us all cause of concern,’ said Gerald Corrigan, former president of the New York Federal Reserve.
Other well-known financial experts expressed similar opinions. C. Feldberg, also of the New York Fed, was to suggest that ‘Sophisticated trading strategies and complex instruments, by their nature, require robust risk management and controls.’ The way I look at IAS 39, it is as a tool aiming to answer Corrigan’s and Feldberg’s concerns. In a compliance sense, good accounting standards provide the necessary initiative for tracking assumed exposure, by putting a price tag on it.
Problems must be identified when they are still small before becoming a torrent;
and damage control must be exercised nearly in real time. Looking at risks ‘later on’ is too late. As Alexander Lamfalussy, former general manager of the Bank for International Settlements and of the European Monetary Institute (today European Central Bank), once said: ‘There might never be a problem. But – and it is a big but – if there were, it would be a very big problem.’ This will be the time when the gaming table is overturned.
The world’s financial system, which serves everybody – not just the banking industry and the hedge funds – cannot afford taking that sort of mega-risk.
Moreover, the result of deregulation is that governments move away from the position of lender of last resort, and companies now need to capitalize to protect themselves and their clients. One of the results of deregulation is that risk is transferred to the private sector.
● The cost of managing risk(s) is thereby moved to the individual firm, and
● Each entity must compete for funds required to finance future growth, as well as to protect itself from exposure(s) taken in the past.
As Eskil Ullberg has it, ‘This situation creates an interesting “battle” for capital in the financial markets. Different instruments may be needed to separate these in different risks and invite investors with the right risk appetite, in order to cre- ate an efficient financing mechanism.’ The size of the risk appetite should be quantified, and IAS 39 helps in doing so.
With reference to the insurance industry, Ullberg poses the question: ‘How can we strike a balance here that both protects the policyholders and meets the needs to free up capital needed for economic growth, without introducing any addi- tional systemic risks in the financial system at the same time?’ And he responded to his query in seven words: ‘The answer may be in the market.’3
This is precisely where IAS 39 is of assistance. It helps (indeed, it prompts) com- panies to assess the market – and then to report to the market by means of reliable financial statements. This is a two-way process, while at the same time market val- ues give the company’s own management a snapshot on risk and return.
Of course, the accounting rules IAS 39, and IFRS at large, while necessary are not enough. To succeed in managing their risks in an effective way and at acceptable cost, new knowledge-enriched mechanisms need to be developed. The real-time balance sheet presented in Chapter 15 is an example.
Even rudimentary tools, like value-at-risk (VAR), may be of assistance as alarm mechanisms.4 Figure 5.2, from the 2004 Annual Report of the Bank for International Settlements (BIS), presents to the reader a dramatic picture: In less than 3 years the value at risk exposure of major investment banks has doubled – and the lion’s share of it is in instruments involving interest rate risk.
Every bank must examine its interest rate risk figures in significant detail, because credit institutions could be affected by changes in interest rates in sev- eral ways. In their banking books, they may be exposed to fixed rate loans, and in their trading book to IRSs, FRAs, and other instruments.
Mismatch, or repricing risk, is the risk that banks’ interest expenses will increase by more than interest receivables when interest rates change. Its origin lies in the maturity mismatches between assets and liabilities. To better appreciate the deeper meaning of this exponentially growing type of exposure, it is proper to bring to the reader’s attention that even in ordinary daily practice, many balance sheets are left exposed to interest rate risk, because:
● Changes in short-term and long-term interest rates happen all the time, and
● These translate into a change in net present value (NPV) of their liabilities, which is a most challenging issue.
In order to lessen the impact of interest rate risk, assets backing the liabilities should be chosen so that they broadly match the duration and convexity of these liabilities.5 This is, however, an ‘ideal’ solution; therefore, one which is easier said than done. The principle is known; the challenge is to execute it.
The market does not necessarily offer all possibilities one might wish to have in doing the ‘ideal’ balancing. At least not every day. For instance, in Euroland there are few bonds available with maturities beyond 10 years, making difficult
2002 2003 2004
TOTAL
INTERSTATE
JUST NOTE DIFFERENCE
Figure 5.2 Value at risk exposure of major investment banks in the 2002–2004 timeframe (Source: Bank for International Settlements, Annual Report 2004, Basel)
the elimination of balance sheet interest rate sensitivities. One way is to turn to equities, often with a dual objective:
● Trying to emulate assets for long-term hedge of liabilities, and
● Attempting to increase the yields on the investment portfolio.
Killing two birds with one well-aimed stone happens sometimes in children’s stories, but not in real business life. Some entities react to their growing balance sheet mismatches by seeking higher returns in the credit derivativesmarket, which is a different gamble. In the aftermath, their portfolio becomes more risky, and
● When equity markets tumble, as had happened in 2000,
● The losses on equity holdings strain the company’s solvency, and its reserves are eroded.
Financial institutions who would like to avoid, or at least prognosticate, adverse effects on their balance sheet, must monitor their exposure to interest rate changes very carefully, doing so at least daily and running stress tests which include the after-effect of changes in interest rates. IAS 39 provides the raw mate- rial for such tests (see also Chapter 16).
For instance, a common stress test is to assess the impact on the balance sheet of an upturn in long-term interest rates of the magnitude seen in 1994, when yields on US 10-year bonds increased from 5.8% in January to 8.1% in November – or 230 basis points. Credit institutions may also be exposed to valuation risk on their investment and trading portfolio, as well as to the risk of an adverse impact of interest rate changes on the:
● Credit quality and ability of customers to service debt
● The evolution of demand for credit
● Basis risk, which arises from imperfect correlation in the adjustment of rates earned and paid on different instruments with otherwise similar repricing characteristics, and
● Optionality, such as prepayment, within the banking book, or in connec- tion to off-balance-sheet items.
Measuring valuation risk in the banking book requires detailed information on remaining maturities as well as purchasing prices. It is also necessary to assess valuation risks in fixed income trading portfolios. Both types of information are rather scarce at the present, but the fact of compliance to accounting standards by IAS 39 is an added stimulus for senior managers to require that their immediate assistants provide better and better results of the type discussed in this section.