A crucial issue with accounting under IAS 39 is the recognition of fair value in categories such as available-for-sale financial assets, defined in section 2. The corresponding changes in balance sheet values must be posted directly to a sep- arate equity item which, as a revaluation reserve, can be equated to unrealized reserves and therefore as additional capital available for prudential reasons.
By contrast, if the alternative accounting option is taken of posting such changes to the profit and loss account, the change in the value of the asset flows directly into retained profits, considered to be core capital. Given this bifurcation, experts suggest that supervisors must find appropriate methods of:
● Treating the different outcomes of such valuations, and
● Making possible comparison to other components of the various classes of regulatory capital.
To appreciate the depth of this argument, it is necessary to recall that banks clas- sify some of their financial assets, including investments not held for trading purposes, as available for sale. This classification is based on management’s determination that these assets are not held for the purpose of generating short- term trading gains. For instance, in connection to compliance to IAS 39 they elect to record changes in fair value of available-for-sale assets in a separate com- ponent of shareholders’equityrather than in income.
● Ifthey made a different election, thenany changes in fair value of unreal- ized gains or losses would be reflected in the income statement, also
● Ifthey reclassify them as trading assets, thenchanges in fair value would have to be reflected in income rather than shareholders’ equity.
Provided the supervisory authority in the jurisdiction in which a credit institu- tion is based allows it, classifying private equity investments as financial invest- ments available for sale, and carrying them on the balance sheet at fair value (with changes in value being recorded directly in equity), presents certain advan- tages. Correspondingly, unrealized losses which are determined to be permanent are recorded in the income statement as impairment charges.
Notice that because quoted market prices are generally unavailable for many of these instruments, fair value is determined by applying valuation techniques which require assumptions and estimates. The reader should appreciate that
different assumptions and estimates lead to different valuation results – which is the weak point of marking to market when there is no direct market for the instrument.
As has been already stated in Chapter 3, and the reader will see repeated in sev- eral places in this book, fair value is no financial penicillin. It is only the better method currently available. Critics are right when they say that the determina- tion of when a decline in fair value below cost is permanent is judgmental by nature, and therefore profit and loss is affected by differences in this judgmental process. Where they are wrong is that they forget P&L under historical costing is pure fiction.
Up to a point, the downside is that unlike fair value accounting for marketable financial instruments, there are considerable problems involved in calculating the fair value of loans and other instruments for which no active and liquid mar- ket presently exists. This is mitigated by the ongoing securitization of all sorts of loans. In other than securitization cases, and inferences based on them, individ- ual modelling and marking to model:
● Is based on assumptions that have to be made,
● These assumptions offer a considerable amount of discretionary choice, and
● There may as well be unavailability of dependable data, and algorithmic insufficiency.
All three reasons can seriously impair the reliability of fair value estimates. (The culture of modelling is discussed in Chapter 7.) Critics also add that full fair value accounting might lead to a greater volatility of results, which could affect the stability of the financial system (as ifgambling in derivatives does not impair it!), and may trigger a change in banks’ behaviour as they:
● Might be prompted to shorten the length of time during which interest rates and capital are locked in, and
● Do other nasty, but undefined, things which may have (equally undefined) negative long-term effects.
A coin, these critics should know, has two faces and both must be examined to judge if it is genuine or fake. Banks cannot argue against modelling fair value when they use, very extensively, models for market risk and (more recently) for credit risk. In fact, some mathematically illiterate credit institutions have used value at risk (VAR) to model credit risk – as VAR99.95– which is one of the most
ridiculous things to have happened so far in the 21st century in the banking industry.3
Instead of irrational criticism, what banks can do, and should do, is to use sim- ulation to study their position and properly balance their assets and liabilities in order to reduce volatility in their unrealized gains and losses. The same is true of insurance companies. Here is the result of a simulation of implementation of IAS 39 by a major credit institution.
● The opening balance of Unrealized Gains/Losses on available-for-sale investments was a net gain of $1 billion, net of taxes.
The gain was due to unrealized marked to market gains on financial investments classified as available for sale. These were principally attributable to private equity investments, but also included other financial instruments held by the institution.
● The opening balance of changes in fair value of Derivative Instruments des- ignated as cash flows hedges, was a net loss of $250 million, also net of taxes.
This was due to unrealized marked to market losses on derivatives designated as cash flow hedges. Such losses were previously recorded in the balance sheet as part of deferred losses. As far as this ahead-of-the-curve financial institution is concerned, all movements within the aforementioned categories are now recorded, each year, in the statement of changes in equity.
Take leasing as an example. IAS 39 applies to lease receivables and payables only in limited respect; yet it could have an important impact. It applies to lease receivables with regard to derecognition and impairment provisions; and to lease payables in respect of the derecognition provisions. But IAS 39 also applies to derivatives embedded in leases – and that can be a source of big differences.
A simulation done by another big bank has shown that the most significant impact of IAS 39 would have been on its leasing portfolio of $1.3 trillion carried off-balance sheet – an amount roughly equal to the gross domestic product (GDP) of Spain. The lesson to retain from these references is that:
● Well-managed banks use technology to reposition themselves
● They don’t spent their time lobbying and staying behind.
In conclusion, the world is changing, as this $1.3 trillion in leases shows. It is better to be proactive than reactive. Therefore, entities should do their home- work using the new standards to define what is wanted and unwanted exposure along the curve shown in Figure 4.1. Banks, insurers, and other institutions
which are stonewalling rather than proactive risk being forgotten in the dust of financial history.