Hard to imagine that economy will always behave as per our models

Published: September 17, 2019 2:28:30 AM

There are assessments that point, with some degree of certainty, to elevated volatility in accounts—P&L in particular—as ‘fair value’ gets to broadly determine what banks report in their annual accounts.

economy, indian economy =, accounting standards, financial crisis, 2008 financial crisis, opinion newsWhile Basel III is still under implementation, a more evolved and, in some ways, simplified Basel IV is on the anvil.

By Anil Kishora

It is a matter of time before the new accounting standards, Ind-AS, kick in for banks in India. These originate from an innovation called IFRS 9 or CECL, if you prefer the American version, that effectively puts accounts and risk together in a blender. How will this initiative pan out? There are assessments that point, with some degree of certainty, to elevated volatility in accounts—P&L in particular—as ‘fair value’ gets to broadly determine what banks report in their annual accounts.

In the aftermath of the 2008 financial crisis, the Basel Committee on Banking Supervision came up with new norms and standards. While Basel III is still under implementation, a more evolved and, in some ways, simplified Basel IV is on the anvil. Rules and regulations continue to originate unabated globally to ensure banks maintain adequate capital, classify their assets appropriately in a timely manner, deliver proper managerial conduct and face enforcement action for breaches or deviations from expected standards. Many would agree that the system is still in shaky equilibrium, with the key stakeholders vying with each other to succeed in finding the right solution to de-risk the system and, of course, the depositors, who are actually the real lenders.

Now, the two premier global accounting standards setting bodies—International Accounting Standards Board (IASB) & Financial Accounting Standards Board (FASB)—have come up with the new mechanism where accounting itself is called upon to capture the risk by adjusting the valuations on the go. Is it set to go down in history as a big game-changing invention in accounting? We don’t know yet, but it is clear that accounting would no longer be a routine and mundane discipline that it has remained since Friar Luca discovered, from merchants of Venice, the good old double-entry book-keeping half a millennium ago.

IFRS 9 trifurcates assets into Stage I, Stage II and Stage III (ominous resemblance to a malignancy that afflicts humans!) and mandates provisions for 12-month Expected Credit Losses (ECL) for Stage I and Lifetime ECL for Stage II. The Current Expected Credit Loss or CECL standard proposed by FASB prefers to front-load lifetime expected losses. The expectation is that such risk-embedded accounting would prevent the next systemic financial fiasco. Conceptually, the new accounting standard appears neat and sensible. What could create problems is the complexity it brings in. Modelling expected losses poses challenges. Data and its dissection apart, it is a bit hard to imagine that the economy would always behave as per our models and not throw up spanners in the works, potentially surfacing unexpected risks. Rapid technological advances or disruptive business models, for example, could lead entire industries to obsolescence, jacking up actual losses. Incurred loss is a reality; expected loss is an estimation.

In general, banks would have done considerable amount of technical heavy lifting to get the mechanics right as part of the preparatory to launch the new IFRS 9 standards or its national variants such as our Ind-AS. However, it is not evident as to how the industry would respond in case the new ECL-driven impairment model starts affecting profitability, making it difficult to practise the existing business models. Long tenor loans, say, for infrastructure or even housing might generate higher ECL. Economic sectors considered high-risk could also be no-go domains for some, if loss modelling shows up unacceptable outcomes. Besides credit ratings of counter-parties, collateral available might gain ascendency in credit decisioning. Banks may need to revisit their views on the kind of credit portfolio they wish to have as also their approach to pricing to minimise volatility in P&L and defend bottom lines. Overall, it may necessitate recalibration of risk appetites.

Transitioning from today’s accounting to the new model would likely pose challenges for the auditing profession as well, in terms of granular data, time and resources they may require to crack through the complexities. Does one rely on model-driven expected loss numbers or dig deeper to assess the assumptions used in modelling the forward-looking scenarios? Extra work on translating accounts into different standards may also add up to costs. Businesses that deal with both the US and the rest of the world may need to deal with both IFRS and CECL—an inescapable complexity in this inter-connected world.

How do we guard against the unintended side effects of the complexity is a theme the global financial community may need to keep revisiting. Possibly, IFRS 9 would get fine-tuned to bring in greater simplicity, just the way Basel IV is emerging to handle unintended consequences and simplify risk measurement approaches. The new fair value IFRS 9 framework is academically appealing. Will it restore stability to the financial world that is looking to get its bearings back since the global financial meltdown? The short answer is ‘no’ but, hopefully, it should be of positive incremental value from risk management perspective.

Potential IFRS 9 outcomes might remind us of that old acronym, VUCA. In such an environment, financial institutions would be better off identifying the risk drivers underpinning their businesses and accordingly reorienting their business models, portfolio strategies and risk management practices.

(The author is DMD & Chief Risk Officer, State Bank of India. Views are personal)

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