Elizabeth A Duke: Regulatory perspectives on the changing accounting
landscape
Speech by Ms Elizabeth A Duke, Member of the Board of Governors of the US Federal
Reserve System, at the AICPA National Conference on Banks and Savings Institutions,
Washington DC, 14 September 2009.
* * *
Good morning. I want to thank the AICPA for inviting me to speak at this year's Conference
on Banks and Savings Institutions. Over the years, this conference has served as an
important forum for the exchange of views on regulatory matters, emerging accounting
issues, new accounting standards, and new auditing considerations.
This year's conference comes at a critical time: Regulators and policymakers around the
world are now evaluating changes to practices and structures to address weaknesses
revealed by the recent financial crisis. At the same time, accounting standard setters are
proposing changes that will, in turn, affect regulatory standards. These changes, along with
those made by regulators and policymakers, will help determine the speed and the durability
of the global financial system's revitalization. Further, the accounting and regulatory changes
made now will help shape future business models for financial institutions and thus influence
credit availability. It is important to ensure that these changes facilitate, not hinder, the
decision-making processes that support financial intermediation and economic activity.
I would like to spend my time with you today talking about current and proposed accounting
standards that will, in my opinion, have the greatest impact on the operation and supervision
of the U.S. banking system. Before I begin, I should define for you my perspective on these
matters. Given my background as a community banker, I feel it is crucial that an accounting
regime directly link reported financial condition and performance with the business model
and economic purpose of the firm. It is difficult for me to comprehend the value of an
accounting regime that doesn't make that link.
As a regulator, I focus on the viability of individual financial institutions and the financial
system as a whole. To be frank, it has been frustrating to try to assess that viability when the
value of an asset is based on the nature of its acquisition rather than the way in which it is
managed or the way in which its economic value is likely to be realized.
And finally, as an economic policymaker, I fully understand the integral role that financial
institutions play in the overall performance of our economy. Equally important are the roles
played by those that trade and those that lend and by the securitization markets. And I
believe a legitimate case can be made for differences in accounting treatment between them
to facilitate financial intermediation and economic activity. You might have guessed by now
that I would like to talk primarily about fair value and loan reserve accounting.
I should also remind you that the views I express are my own and do not necessarily reflect
the thinking of my colleagues on the Board of Governors or Board staff.
Relevance and reliability
I think it might be useful to discuss current and proposed accounting standards by first
considering the concepts of relevance and reliability.
In terms of relevance, the measurement principle should reflect the manner in which entities
actually use financial instruments. In this regard, the business model and risk-management
approach taken by the reporting entity - as well as the way in which the value of the
instrument itself is likely to be realized - should be factored into the measurement
determination.
If the business model is predicated on the trading of financial instruments for the realization
of value, or other strategies that essentially focus on short-term price movements, then fair
value has relevance. In the trading business model, reporting fair value focuses risk
management on short-term price movements and in most cases incentivizes management to
define the organization's risk appetite and to mitigate risk through hedging or other means.
Fair value also incentivizes the entity to raise and maintain capital at a level sufficient to
cover the price volatility of its assets. For example, if the business model is an
originate-todistribute model, then fair value has relevance.
In contrast, if the business model is predicated on the realization of value through the return
of principal and yield over the life of the financial instrument, then fair value is less relevant.
Consider, for example, a bank that finances the operations of a commercial enterprise. The
realization of value will come from the repayment of cash flows. Risk management is based
on an assessment of the borrower's creditworthiness and the entity's ability to fund the loan
to maturity. In this case, the accounting should incentivize the entity to maintain sufficient
funding to hold the instrument to maturity and to hold a sufficient amount of capital to cover
potential credit losses through the credit cycle, preferably in a designated reserve. Indeed,
the use of fair value could create disincentives for lending to smaller businesses whose credit
characteristics are not easily evaluated by the marketplace.
Admittedly, some have used the business model argument to manipulate accounting results.
But the actions of those entities do not diminish the relevance of the business model to the
measurement principle. Indeed, over time if the valuation model is not relevant to the
business model, the business model itself is likely to change. Rather, the lesson to be
learned from such manipulation is that we - preparers, users and auditors of financial
statements - need to be vigilant in evaluating actual business practice, and restrict the use of
particular measurement principles to the relevant business models.
To this end, safeguards should be implemented to eliminate a firm's ability to overstate gains
or understate losses by switching back and forth between business models or by
reclassifying assets from one business segment to another. For example, from a regulatory
perspective, assets in a financial institution's liquidity reserve, by their nature, imply utility
through sale and, therefore, should be valued at market price.
In terms of reliability, the measurement principle should reflect the ability of all types of
entities to calculate a value within a reasonable range of confidence throughout the
economic cycle and the life of the financial instruments. There is a good deal of reliability
when the fair value of a financial instrument is observable in an active market.You
accountants refer to these observable inputs to fair value as level 1. As you leave the active
markets and get into the so-called level 2 and level 3 inputs to fair value measurements, an
entity's ability to reach a consistent fair value or an estimate of fair value within a reasonable
range of values for a particular financial instrument significantly diminishes. As the recent
financial crisis has shown us, a financial instrument's fair value can vary widely among
entities in similar markets. And the existence of wide variability in valuation models makes
comparisons between entities difficult if not suspect.
The reliability of amortized cost is not as questionable. Amortized cost simply is the amount
paid to acquire a financial asset, adjusted for any unaccreted discount or unamortized
premium. All entities calculate amortized cost using the same formula. Of course, amortized
cost is not a panacea. Entities purchase assets at different times and the timing of expected
cash flow changes can result in different measurements for the same financial instruments. If
the receipt of future payments is in doubt, impairment must be estimated.
The use of a reserve for credit losses helps distinguish between contractual amounts due
and payment uncertainty created by economic or borrower-specific conditions. Current
accounting standards permit credit reserves only for losses likely to be realized in the short
term. Lenders regularly adjust credit standards to achieve life of loan profitability given
through-the-cycle estimates of credit loss. They should similarly be able to estimate
throughthe-cycle reserves as reliably as short term likely losses.
The stress test
Accounting treatment issues are critically important in the regulatory evaluation of financial
institutions' safety and soundness. The Supervisory Capital Assessment Program (popularly
known as the stress test) provides a window into the likely future of bank supervision as well
as the accounting issues encountered by regulators in evaluating capital adequacy. The
stress test was a simultaneous, horizontal review of the 19 largest financial institutions in the
United States. The review was led by the Federal Reserve, but conducted jointly with other
federal banking regulators. In essence, we focused on three key pieces of information -
preprovision net revenue, potential losses, and final equity capital.
Pre-provision net revenue and potential losses were estimated under two different economic
scenarios, a baseline scenario and one that was more stressful. Importantly, losses in the
trading book were estimated using indicators of financial stress and market volatility while
losses in the loan book were estimated using economic indicators to assess probability of
default and projections of asset prices to estimate loss severities. In this way, the stress test
held to the principle of relevance, while statistical history provided us with some measure of
reliability. The stress test was a forward-looking exercise and losses were estimated over a
two-year horizon: 2009 and 2010. Given that the two-year horizon was likely to be one of the
most stressful time periods in our history, the credit loss estimates would come closer to
approximating through-the-cycle losses than the reserve amounts calculated under current
accounting standards.
Three of the banks that participated in the stress tests had acquired significant loan portfolios
through business combinations. Given the elimination of the pooling-of-interest method, the
advent of AICPA Statement of Position 03-3 (SOP 03-3) accounting, and the prohibition on
presenting an allowance for any acquired pools of loans, it was very challenging to determine
the amount of credit risk that was already captured in the carrying amount of these acquired
loans. Essentially, we had to determine the level of credit risk that would have been present
under the pooling-of-interest method and adjust those amounts under the economic
scenarios. Adjusting our measurement of these portfolios for pre-provision net revenue, loan
loss, and capital proved quite challenging. I would expect it to be similarly challenging for
analysts and investors to make similar adjustments in order to set benchmarks and compare
performance, of an individual bank over time or between two or more banks. This is a case
where I believe we have experienced a reduction in transparency and have lost valuable
credit information on acquired loans.
I recognize that the Loan Loss Disclosures project at the Financial Accounting Standards
Board (FASB) is an attempt to provide some of this information by (1) requiring more
disclosure of credit risks generally and (2) requiring the disclosure of the total carrying
amount and the total unpaid principal balance of impaired FAS 114 loans for both loans with
and without a related allowance for credit loss. However, reserve coverage and loss ratios
are calculated using amounts shown in the financial statements. Allowing different treatment
of portfolios acquired through business combinations and originated portfolios will make
comparisons difficult and will make norms and averages less meaningful over time.
In calculating capital requirements, we treated off-balance-sheet entities as if they were
carried on the balance sheet. We consulted with the FASB for the most current thinking
about what would be consolidated under the accounting rules they were finalizing.
To recap, in the stress test we analyzed 19 financial intermediaries engaged in a mix of
trading and lending businesses. We conducted this analysis on behalf of the U.S. taxpayer
who had become a primary investor in these institutions. And we analyzed them in a way
that, in my opinion, best characterizes the risk and performance of the entities:
•
We evaluated trading assets on a fair value basis;
•
We evaluated loan assets on the basis of expected credit loss through an adverse
cycle;
•
We evaluated assets based on the way they were managed rather than the way they
were acquired; and
•
We included assets held both on- and off-balance sheet.
And finally, we used this analysis to estimate the capital buffer needed to protect the entity in
an adverse scenario. We published both our methodology and our findings. While I am
normally firmly opposed to making public confidential supervisory information, in this case,
we were able to respond to high levels of uncertainty and speculation by publishing our
findings. Marketplace confidence seemed to rise upon the publication of results and the
subsequent successful capital raises by the firms.
Now that some measure of confidence has been restored and financial strains are receding,
it is time to turn our attention to the lessons learned in the crisis. And to ask: How can we
prevent future crises? Accounting standard setters, regulators, and policymakers around the
world are discussing and proposing preventative measures. Now the challenge lies in
integrating those changes smoothly and seamlessly.
Accounting issues identified during the crisis
A number of groups have analyzed the role that accounting played during the crisis and have
made recommendations to strengthen accounting standards and the standard-setting
process. Although accounting was not the cause of the financial crisis, certain accounting
measures, such as the use of fair value accounting for illiquid financial instruments and the
impairment model for loans and debt securities, have drawn considerable attention.
Throughout the crisis, there were considerably fewer actual market transactions available for
use as reference prices for fair values. At the height of the crisis, there was such little market
activity that serious consideration was given to abandoning the use of fair value for a period
of time. Even now, the debate continues about whether fair value is the appropriate
measurement attribute for debt securities and other financial instruments, particularly in less
active markets.
Similarly, there were serious concerns about the approaches used to determine the
impairment of loans and certain debt securities during the crisis. Some argued that the
approaches available inhibited firms from recognizing credit losses on loans sooner and
artificially required the recognition of losses on debt securities. Standard setters responded
by providing guidance on the determination of fair values in the stressed market environment
and the determination of financial instrument impairment. This was a very challenging period
for financial statement preparers, users, standard setters, and regulators.
FASB and IASB approaches under consideration
Standard setters are now actively engaged in the discussion of the appropriate accounting
principle for measuring financial instruments. Currently FASB and the International
Accounting Standards Board (IASB) are pursuing measurement approaches that diverge in
important ways.
FASB's approach would measure all financial instruments (assets and liabilities) at fair value
through the income statement or other comprehensive income. This would mean that an
entity's business strategy for investing in securities and originating loans would not be taken
into account. FASB is willing to disclose the amortized cost of these financial instruments on
the balance sheet along with the fair value, but there is a catch. The FASB approach would
modify the income statement to include all changes in fair value whether or not they are
included in other comprehensive income. Reflecting market value fluctuations of all assets
through the income statement would significantly increase the volatility of reported bank
earnings, likely leading to changes in risk-management practices. At the extreme, this
approach could incent all financial intermediaries to adopt a trading or investment banking
business model.
On the other hand, IASB's approach would measure financial instruments at amortized cost if
they have characteristics of a basic loan and are managed on a yield basis. Under the IASB
approach, characteristics of a basic loan are fairly narrowly defined. For example, only the
most senior tranche of an asset securitization might qualify for amortized cost. Similarly, any
loan with any unusual provision might not qualify for amortized cost. This approach would
measure all other financial instruments at fair value predominantly through the income
statement. There is a narrow exception for fair valuing certain strategic equity investments
through other comprehensive income. Consistent with the FASB approach, the IASB
approach would modify the income statement to include all changes in fair value whether or
not they are included in other comprehensive income.
By now, you have gotten the picture that both of the approaches under consideration would
constitute a significant departure from current practice. Both of these proposals raise a
number of concerns for me:
•
From the standpoint of relevance and reliability, the FASB and IASB approaches
would not accurately reflect the traditional commercial banking model. Indeed, the
imbedded incentives would actually favor "originate to distribute" rather than
"originate and hold" lending models.
•
Second, we have very little actual experience in fair valuing liabilities. Using fair value
for liabilities introduces a new set of incentives and risk exposures for management.
•
Thirdly, no market currently exists for non-government-guaranteed, small business
loans. The lack of fair value information for these types of loans could actually
discourage small business lending.
•
Fourth: Smaller banking companies likely will incur substantial costs and experience
great difficulty in applying the new standards. But will financial statement users see
any real benefit?
•
And finally, the two Boards are planning to exchange views and work products, but
are not duty-bound to achieving a single converged standard. If the approaches are
implemented along different timelines in the United States and abroad, they could
bring the two sets of standards further apart and possibly incent some governmental
bodies to mandate an approach in order to level the playing field.
Retaining both lending and trading models
My preference would be for standards that recognize both lending and trading business
models for financial intermediation even when they exist within the same firm. My wish list
would include the following:
•
Trading assets shown at fair value with market value gains and losses recognized
through the income statement;
•
Assets held for secondary liquidity shown at fair value with market value gains and
losses recognized in the capital account through other comprehensive income;
•
Assets held to maturity and managed for yield and return of principal over time shown
at amortized cost with a reserve reflecting life-of-loan or through-the-cycle potential
credit losses; and
•
For business combinations, identical accounting treatment for acquired assets and
similarly managed assets on the acquirer's balance sheet.
Regulatory changes
In terms of regulatory changes, our current regulatory capital framework needs to be revised
to ensure that banking organizations have a level of capital sufficient to facilitate lending,
while also ensuring safe and sound operation throughout the economic cycle. Work is
underway to develop an approach that would allow banks to retain more capital in good
economic times and to allow this excess or buffer to be reduced as the economic cycle
worsens. The goal is to have a level of capital that is sufficient to support lending, while
maintaining safety and soundness. The challenge is to develop an appropriate target for this
excess amount and to identify the right economic trigger for determining when this excess
should be reduced. This is a delicate balance.
In addition, the elements that we consider to be tier 1 capital in our current framework need
to be revised. Since our framework starts with components of equity capital as measured
under generally accepted accounting principles (GAAP), we are carefully evaluating every
element of regulatory capital that is treated differently in regulatory capital than in GAAP. For
example, GAAP equity includes accumulated other comprehensive income (AOCI) and the
current regulatory framework neutralizes the impact of certain items in AOCI such as
unrealized holding gains and losses on available-for-sale debt securities.
And finally we are coordinating capital standard setting with our counterparts in other
countries. To the extent that GAAP and accounting standards in those countries are different,
our capital definitions may also differ.
Impact on securitization
Finally, I'd like to offer a quick word of caution on accounting for off-balance-sheet items and
the future of securitization markets.
Our financial system has become dependent upon securitization as an important
intermediation tool. During the crisis, securitization markets ground to a halt. The Federal
Reserve's Term Asset-Backed Securities Loan Facility (TALF) has helped restart activity in
some markets, such as securities backed by auto loans or credit card receivables. But the
CMBS market is still very weak and the market for newly issued, private-label RMBS remains
closed. And although the TALF has been successful, it is a short-term facility that was only
intended to give the markets and policymakers time to restructure the securitization model to
make the securitization markets more viable going forward.
The recent G20 agreement calls for a retention of risk, or "skin-in-the-game" approach for
asset securitizations. It also calls for higher capital standards and a leverage ratio for all
banks. If the risk retention requirements, combined with accounting standards governing the
treatment of off-balance-sheet entities, make it impossible for firms to reduce the balance
sheet through securitization and if, at the same time, leverage ratios limit balance sheet
growth, we could be faced with substantially less credit availability. I'm not arguing with the
accounting standards or the regulatory direction. I am just saying they must be coordinated
to avoid potentially limiting the free flow of credit.
We will learn more about the impact of the new accounting rules on securitization activities
as banking organizations implement the new standards. We will also learn more about the
impact of our regulatory capital regime on securitization activities as we evaluate the
responses to our proposed changes to the regulatory capital guidelines. In the past,
accounting rules and regulatory capital guidelines have been drivers for how the
securitization model has been structured. As policymakers and others work to create a new
framework for securitization, we need to be mindful of falling into the trap of letting either the
accounting or regulatory capital drive us to the wrong model. This may mean we have to
revisit the accounting or regulatory capital in order to achieve our objectives for a viable
securitization market. A healthy economy needs an array of tools for financial intermediation
and we need to be careful not to be overly punitive to this particular tool. We just need to
focus on providing the appropriate incentives, oversight, and accountability.
Conclusion
The financial crisis has certainly highlighted the need for a safe and stable financial system.
To promote confidence and attract capital to the system, we need financial statements that
provide maximum insight into the financial condition and risk positions of financial
intermediaries. We need supervisory oversight and regulatory constraints, such as regulatory
capital, that provide safeguards and incentives that support our objectives of prudent
provision of credit and sustainable economic activity. And the accounting and supervisory
frameworks need to recognize and support all viable forms of financial intermediation
regardless of whether it occurs in the traditional lending model, the trading model, the
securitization model, or some other business model. In this regard, I believe it is important to
show in the statements themselves the numbers needed to construct ratio analysis between
firms or of individual firms across time.
Finally, I believe that accounting standard setters, regulatory bodies, and lawmakers have a
vested interest in working together to ensure the oversight mechanisms, reporting
frameworks, and other elements of the revitalized financial system operate in a manner that
is both stable and efficient.