Bank Regulatory Capital: Brewing Storm over Basel III Removal of Financial Reporting Information Filter

Categories: EMEA, FASB, Financial Reporting, Financial Statement Analysis, IASB, IFRS, Standards, Ethics & Regulations (SER)
Bank Regulation

It remains challenging for investors to fully anticipate the consequences of forthcoming bank regulatory requirements, especially across interrelated strands of regulation. A case in point is a Basel III requirement eliminating filters relating to financial reporting information. Historically, country prudential regulators could decide whether banks within their jurisdiction could deduct particular gains or losses from accounting book equity when determining regulatory capital (i.e., the application of prudential filters). For the purposes of determining regulatory capital, Basel III eliminates the application of prudential filters to unrealized gains or losses of financial instruments categorized as “available for sale” (AFS). AFS securities are recognized at fair value on the balance sheet with associated gains or losses recognized through the “other comprehensive income” (OCI) statement. AFS assets typically comprise between 10% and 20% of total assets of a global bank’s balance sheet. For example, HSBC reported AFS assets in the 2012 annual report that are equivalent to 15.8% and 15.4% of total assets at the end of 2012 and 2011, respectively.

The furor over eliminating AFS filters is highlighted by an article in the March 2013 edition of Risk Magazine. The article alludes to the belated recognition, especially amongst several U.S. banking industry players, of likely key impacts of this change on regulatory capital levels and volatility. The vociferous concerns raised by U.S. banking industry stakeholders regarding this requirement could be a key driver behind the U.S.’ delay in adopting Basel III.

Considering the currently low interest rates in the developed world, the Risk Magazine article points to the potential for a precipitous decline in the value of interest-rate-sensitive AFS debt securities and a corresponding fall in the capital levels should rates rise. An analysis of 14 U.S. banks showed that under certain scenarios, a 100-basis-points increase in interest rates could result in an incremental core Tier 1 capital shortfall of greater than $20 billion if Basel III were applied by U.S. banks.

Key Consequence: Likely Increase in Regulatory Capital Volatility and Capital Shortfalls

All things being equal (i.e., similar portfolio holdings by banks and the same accounting income recognition outcomes), eliminating AFS prudential filters, as required under current regulatory capital reporting, would likely result in a higher level of replenishment of loss-absorbing capital during economic downturns. This is because not applying a filter towards unrealized AFS gains (losses) would increase (decrease) the adjusted book equity (i.e., regulatory book equity). In turn, the likely unrealized AFS losses in an economic downturn would increase the amount of required regulatory capital replenishment during such periods. Effectively, the exclusion of unrealised AFS gains or losses from regulatory capital, as allowed in the guidance preceding Basel III, minimised both the required regulatory capital replenishment and regulatory capital volatility.

Indeed, the European Banking Authority (EBA) 2011 recapitalisation tests shows that prudential filters resulted in 55% of gains or losses related to sovereign exposures being excluded from regulatory capital levels. Similarly, the regulatory capital composition and reconciliation schedules from recently issued 2012 annual reports of two large global banks (Barclays and HSBC) show that AFS unrealized gains or losses are often significant. For the year 2012, HSBC OCI shows significant AFS fair value gains of USD 6.4 billion, or 4.6% of core Tier 1 capital. Both Barclays and HSBC OCI statements show significant swings in AFS amounts reported between 2010 and 2012. However, these particular amounts may not precisely reflect the unrealized AFS gains or losses. Still, these swings are indicative of the volatility-enhancing impact of AFS on regulatory capital under the new Basel requirements.

AFS

Heightened Focus on Accounting Standards by Banking Industry Players

As the Risk Magazine article notes, there is an expectation that regulatory capital volatility would increase along with potential capital shortfalls if Basel III requirements were applied under current or prospective U.S. GAAP requirements.

Within the International Financial Reporting Standards (IFRS) reporting world, a comment letter by the European Banking Federation (EBF) to the Basel Committee on Banking Supervision (BCBS) indicates that banking industry players were initially supportive of the decision to eliminate AFS prudential filters. They apparently anticipated that the updated financial instruments accounting standards (i.e., IFRS 9, Classification and Measurement of Financial Instruments) would no longer have required the AFS category and, therefore, volatility of AFS items was not expected to be an issue. IFRS 9 will replace the current financial instruments recognition and measurement standard, IAS 39. The original version of IFRS 9 had only two classification categories (fair value through profit and loss and amortized cost); stakeholders seem to have assumed that because AFS would disappear with IFRS 9, the Basel III change would be inconsequential as there would be no unrealized AFS gains or losses. Subsequently, there are concerns that recent updates to IFRS 9 reintroducing a classification category that seems similar to AFS, when taken in conjunction with Basel III, could lead to regulatory capital volatility.

Overall, it appears likely that bank industry stakeholders may end up lobbying to do away with this updated Basel requirement, or they could end up pushing for changes to financial instruments accounting standards in order to mitigate regulatory capital volatility.

Focus Should Remain on Accounting Standards Tailored to Investors’ Needs

Putting aside the mentioned banker concerns, CFA Institute previously has expressed preference towards the application of prudential filters — rather than create a situation in which there are competing needs for financial reporting information between investors, who require unbiased information, and prudential regulators, whose aversion to the volatility of earnings and bank net asset values could influence their financial reporting requirements.

Both the International Accounting Standards Board (IASB) and Financial Accounting Standards Board (FASB) are currently updating their respective financial instruments classification and measurement standards. For the banking industry stakeholders, eliminating the AFS prudential filters under Basel III risks shifting focus from whether the financial instruments accounting standards updates are useful to investor decision-making to whether these accounting standards impact on regulatory capital volatility. Hence, investors need to be alert to the interaction and consequences of updates to both Basel III and accounting standards.


Photo credit: iStockphoto.com/georgeclerk

3 comments on “Bank Regulatory Capital: Brewing Storm over Basel III Removal of Financial Reporting Information Filter

  1. Rajesh Lucknauth said:

    During market downturn, when the available for sale securities are disposed, the losses turn from unrealised to realise, hitting the equity as well as the cash flow. The market downturn is often accompanied with liquidity crisis and banks will be urged to reduce their liquidity injection into the financial system. I am sure that it is too soon for the world to have a GFC 2.

  2. Vincent Papa, PhD, CFA said:

    The blog post primarily touches on capital shortfalls of banks that would be experienced under Basel III, as reported in the March 2013 Risk magazine, should AFS assets (i.e., debt securities) decline due to rising interest rates.

    You raise a different and interesting point regarding the possible consequential impacts which may be reflected in decisions by banks to either hold or sale AFS assets (i.e., those assets being held for liquidity coverage purposes). A good analysis of the possible impacts of the Basel III requirement on liquidity coverage requirements is included in the mentioned March Risk magazine article.

    I would agree with the thrust of your comments — different moving parts can indeed snowball into something bigger.

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