Financial Stability and Transparency – Consistent Objectives?

Published June 2012

In discussions about what the primary goal of standard setting should be, the objectives of transparency and financial stability are often seen as being juxta-positioned.

The financial crisis has for many added fuel to the debate and highlighted the question of the interaction between financial reporting standards aimed primarily at investors for capital allocation decisions, and their impact on other public policy objectives, including prudential regulation, sustainability, anti-corruption measures and others.  The question is how, and to what extent, these perspectives can be reconciled.

While these tensions are not new, the financial crisis has served to bring them to the surface again.

Transparency – The Answer?

The International Accounting Standards Board and the IFRS Foundation have expressed the view that tensions among the varying objectives are overstated, and that the various objectives are all served by transparency in financial reporting.  In a recent speech, the IASB Chairman was very clear about what standard setters cannot do, they cannot (and will not)  make items appear to be stable when they are not,  they can however contribute to increased transparency which in turn gives prudential regulators and central banks the possibility to react with the information available to them.

The confidence of all users of financial statements in their transparency and integrity is critically important for the functioning of capital markets, efficient capital allocation, global financial stability and sound economic growth.

IASB Addresses the Issues

Three areas in which the IASB is engaged and which are especially important in connection with the financial crisis and the current Euro crisis are:

• Tightening of consolidation requirement to prevent undesirable off-balance sheet financing – Improved consolidation and disclosure requirements have been included in the ‘package of five’ standards published in May 2011. Due for mandatory implementation for periods beginning 1 January 2013, indications are that they will be endorsed for use by European companies later in 2012 but that mandatory implementation will be deferred to 2014
• Judicious use of fair value accounting to show inherent volatility in business models and markets – During the financial crisis there were often calls to abandon fair value accounting as it was believed to lead to artificial volatility. However, the financial sector is an industry with substantial inherent volatility, not showing it would most likely diminish transparency not increase it. The IASB is very aware that for some financial instruments, amortised cost is deemed to provide more relevant information than short-term fluctuations.  Therefore, IFRS 9 continues to adopt a mixed measurement model. The publication of IFRS 13 Fair Value Measurement and its implementation in 2013 represent significant progress in achieving a consistent approach to fair value measurement and associated disclosures
• Providing a well-functioning impairment model for reliable and creditable amortised cost measurements - The current impairment model which is based on  incurred losses has been widely criticised, probably with some justification.  However it is increasingly apparent that the model also suffered from a less than vigorous application as triggers during and in the run up to the financial crisis to start providing for impairment were abundant yet for various reasons were ignored. Both the IASB and the FASB do recognise the shortcomings of the incurred loss model and are developing a model based on expected losses. Some differences continue between them as to the preferred solution and there may be some way to go. However, the direction being taken is likely to make a substantive contribution to improved transparency.

The most recent joint update note from the IASB and the FASB, in April 2012, indicates that they are continuing to work expeditiously on reaching converged solutions to core projects on financial instruments, leasing and insurance by mid-2013.  A final standard on revenue recognition may be expected in early 2013.

Disclosure – Striking the Right Balance

A major concern of investors and other market participants is the understandability and relevance of the financial information being produced, which is the corner-stone of the platform on which their economic decision-making is based.  The fundamental importance of achieving the most reliable and appropriate recognition and measurement basis is obvious, and subject to much attention by standard-setters.  Their focus must also be on completing the message and achieving the right balance of disclosure.

A recent development in the drive for financial regulatory reform is the announcement by the Financial Stability Board (FSB) of a private sector ‘Enhanced Disclosure Task Force’ (EDTF) to develop principles for enhanced disclosures by financial institutions, based on current market conditions and risks, including ways to enhance the comparability of disclosures.

The FSB was established through the G7 and G20 in 2007 to coordinate at international level the work of national financial authorities and international standard setting bodies and to develop and promote the implementation of effective regulatory, supervisory and other financial sector policies.

What Do Market Participants Look For?

The creation of the EDTF follows on from an FSB hosted roundtable on risk disclosures by financial institutions held in December 2011.  Some of the key themes that arose during the roundtable discussions are:

• A general preference for principles-based disclosures, rather than rules-based, with a call for measures to improve comparability, such as more consistent risk disclosure formats and templates
• Improved qualitative disclosures about governance, risk management oversight and related controls, and qualitative and quantitative disclosures about risk management practices, risk exposures and remuneration
• The relevance of information about a financial institution’s risk appetite and enhanced relevance of risk disclosures by increased consistency with information used internally for risk management purposes
• More use of executive summaries of the key risk categories, which should include key metrics on entity-wide risk exposure and risk management effectiveness.

There were many comments also with regard to enhancing disclosure in specific areas including credit risk, liquidity risk and capital adequacy.

A general view expressed was that in the current stressed environment, voluntary risk disclosure initiated by some in the private sector may not of itself be sufficient to restore confidence quickly and that proactive involvement by the official sector, regulators and supervisors, is essential to moving forward.

At its most recent meeting the G20 Financial Ministers and Central Bank Governors reaffirmed their commitment to the financial regulatory reform agenda and also urged the IASB and the FASB to meet their target of issuing standards on key convergence projects by mid-2013.

What is clear is that substantial work is being done to move the agenda forward on financial stability and accounting reform.  Perseverance is required to develop and reach consensus on the solutions that work best.

First published in Finance Dublin Online.