Overview of Bank Accounting

Chu Yeong, Lim

Bank Balance Sheet Composition

Main assets

Loans & advances (includes interbank) : 45%

Trading securities & securities at FV: 20%

Financial investments held to maturity : 15%

Derivatives : 10%

Main liabilities

Customer deposits : 50%

Interbank borrowing : 5%

Trading interbank & customer deposits & debt securities issued : 20%

Derivatives : 10%

Shareholder’s equity : 6%

HSBC annual report (2009)

Key Balance Sheet Assets

(1) Cash and balances held at central banks

Low yields, held to meet statutory liquidity requirementsHighly liquid assets covered in statutory liquidity requirements:Cash and balances held at central banks, government securities, repo securities

Opportunity cost between low yields and interbank lending rate factored in cost of funding to the users of fundsFormula to factor this cost in cost of funds = [100% x original cost of funds – 10% x (yield of liquid assets – interbank lending rate)]/(100% - 10%)This assumes statutory liquid asset requirement to be 10%.

Key Balance Sheet Assets(2) Trading assets

Held for trading and fair valued under IAS 39 and FAS 115 accounting standard classificationse.g. equity and debt securities, reverse repos, loans traded in market

(3) Financial assets designated at fair value

Elected/designated for fair valuation under IAS 39 and FAS 159Financial assets e.g. available for sale (AFS) securities, securities held for repurchase/resale, loans held for sale, equity investments and loan commitments

(4) Financial InvestmentsHeld for maturity securities (debt & equity)

Key Balance Sheet Assets

(5) Loans and Advances

Loans and advances to banks and non-banks

Includes repos and reverse repos – collateralized borrowing and collateralized lending "Repo 105“ in Lehman treated as sale of inventory on basis of overcollateralization, to reduce leverage ratios.Net carrying amount shown as principal amounts less loan loss allowances/provisions.

Accounting standards (Securities)

IAS 39 & FAS 114

3 main categories:

(a) Held to maturity: management has intent to hold securities to

maturity, security is accounted for at amortized cost , interest accrued,

realized gains/losses on sale of securities,

(b) Trading: security held for short term sale purposes, security

accounted for under fair value accounting,

(c) Available-for-sale: neither held for trading or to maturity (statutory

liquidity requirements), changes in fair values recognized in other

comprehensive income & transferred to earnings upon sale of security - Impairment test: if decline in asset deemed to be other than

temporary, impairment charge made to income statement.

Accounting standards (Fair Value Measurement)

FAS 157 (exit price in principal or most advantageous market)• Level 1 assets

- most liquid asset, observable market prices e.g. quoted equities, quoted bonds, spot FX

• Level 2 assets- market prices of assets not directly observable, but fair values can be derived from models using directly observable market inputs such as interest rate yield curves and option volatilitiese.g. convertible bonds, interest rate swaps, FX swaps

• Level 3 assets- valuation model uses unobservable market data e.g. MBS

Fair value adjustments for levels 2 & 3 assets: bid-offer spreads, liquidity

premium.

Accounting standards (Fair Value Measurement)

IAS 39

• Active versus Inactive marketsAssessment criteria:

a) levels of volume and activity, b) if transaction prices are stale,c) consistency in price quotes from brokers/market makers,d) correlations among similar assets,e) price levels that may indicate liquidity concerns,f) bid/offer spreads beyond normal dealer profits

Accounting standards (Fair Value Measurement)

• Orderly or disorderly transactionAssessment criteria (a transaction is deemed disorderly if a condition issatisfied):

a) Structured product had no sufficient exposure to the market based on usual marketing period,

b) If product has been marketed to single buyer,c) If seller is in state of insolvency,d) Transaction price is outlier compared to prices of similar products

If market is inactive and transaction is disorderly,Mark to model is used.

Accounting standards (Fair Value Option)

FAS 159 - Intention is to reduce financial statement volatility and reduce onerous documentation requirements under FAS133. - Management given substantial discretion to elect fair value e.g. assets classified as held to maturity or available for sale, but funded

by derivatives.

IAS 39- Revision in 2005 allows a firm to designate a financial asset or afinancial liability on initial recognition as one to be measured at fair value. - Designation is irrevocable. Conditions include:a) selected financial asset/liability must contain embedded derivatives,b) selected financial liability with amounts contractually linked to

valuation of asset at fair value,c) changes in financial instrument value offset changes in fair values

of financial assets/liabilities such as derivatives.

Accounting standards (Derivative accounting)

IAS 39 & FAS 133 - Trading derivative fair values recognised in income statement.- Derivatives designated as hedging, accounting treatment as follows: a) Fair value hedge - derivatives hedge the exposures to changes in fair value of fixed rate exposures; derivatives’ gains/losses recognised in earnings.

b) Cash flow hedge – derivatives hedge cash flows of forecasted transactions (floating rate exposures); derivatives’ gains/losses recognised in other comprehensive income.

c) Derivatives hedge foreign currency exposures of net investments in foreign operations, derivatives’ gains/losses recognised in other comprehensive income.

Tests of hedge effectiveness based on fair value correlations between hedging and hedged items.

Accounting standards (Derivative accounting)

IAS 39 & FAS 133

Derivatives embedded in financial instruments (e.g. dual currency deposits), bifurcation required if embedded derivatives are not related to underlying host instrument:

a) Host instrument is interest rate related while derivatives are foreign

exchange or equity related such as dual currency deposits, equity linked deposits;

b) If embedded derivatives are interest rate related, the investor may not recover substantially the initial investment or the returns of

structured product is at least twice that without the embedded derivatives e.g. range accrual deposits.

Accounting standards (Loan Loss Provisions)

IAS 39 & FAS 114- Incurred loan loss allowances/provisions method requires specific andgeneral provisions.- Objective evidence of loss event for specific provisions e.g. payment defaults.- Evaluation criteria for general provisions:a) Risk ratings (external e.g. Moody’s and internal),b) Loan types (e.g. credit cards versus loans to small corporate),c) Product lines/industries of borrowers (e.g. volatile industries such

as construction or industries in downturn)d) Geographical segments e) Economic conditions (current and forecasted)f) Estimated delinquencies and payment historiesg) Credit scores of retail customersh) Foreclosure rates for mortgage loans.

Accounting standards (Loan Loss Provisions)

IAS 39 & FAS 114Loan future cash flows discounted at original effective rates to derive the loan asset value and provisions to be recorded.

E.g. 5 year loan of £15k to be received at end of each year at original effective interest rate of 7%. One year before maturity, evidence of impairment and expected cash flow is £7.5k.PV of loan = £7.5k discounted at 7% = £7k Impairment loss = £15k - £7k = £8k. Interest accrual = £7k x 7% = £490.

Incurred loan loss accounting method severely criticised for delayingrecognition of loan losses and being pro-cyclical (Financial Stability Forum 2009; Turner, 2010).

Accounting standards (Securitization)

Securitization: sale of loans and receivables to investors

4 players in securitization market:a) Banks – originators of loansb) Securitizers – separate securitization entities that house securitized assetsc) Investors in securitized assetsd) Guarantors – that provide guarantees or liquidity support

Key accounting question: Should securitized assets in the securitization entity be consolidated?

Securitization entity consolidated with issuer when former does not have legal right to foreclose on the securitized assets.Rapid growth in securitization many securitization entities which do not have such rights were not consolidated. (Ryan, 2008)

Reform of Accounting standards

Revisions to IAS 39 in the following phases (IFRS 9):Phase 1 – derecognition criteria (ED – April 2009)Existing derecognition conditions: a) any substantial transfer of risks and rewards,b) who has control over assets,c) whether transferor has continuing involvement in assets.

Revisions – simplify the conditions and use the key tests of control.

Phase 2 – classification & measurement criteria (ED – July 2009)Eliminate bifurcation between financial host product & embedded derivative. 2 conditions of measuring financial asset at amortised cost:a) when instrument has basic loan features b) when instrument is managed on contractual basis.

Reform of Accounting standards

Phase 3 – amortised cost & impairment Expected loan loss model

Future expected cash flows (factor expected credit loss over life of the loan) at original effective interest ratesRecognition threshold of loss event removed.

Key argument against use of fair valuation for mortgage loans is that they are expected to be held for long term & accounting mismatches against the liabilities (causes earnings volatility that are not related to economics).

Phase 4 – hedge accounting (ED - 1H 2010)

Phase 5 – classification & measurement of liabilities (ED not released yet)

Base case example: 5 year fixed rate loan with principal £1m, coupon rate 10%, 5% expected loss on maturity

Comparison of Expected Loan Loss versus Incurred Loan Loss models

Deloitte, 2010

0

20000

40000

60000

80000

100000

120000

1 2 3 4 5

Years

$

EDImpairmentbal sheetallowance

EDImpairmentP&L

IAS39 P&L

Scenario 1: At start of year 2, expectation of loss revised to be 10% at maturity

Comparison of Expected Loan Loss versus Incurred Loan Loss models

Deloitte, 2010

0

20000

40000

60000

80000

100000

120000

1 2 3 4 5

Years

$

EDImpairmentbal sheetallowance

EDImpairmentP&L

IAS39 P&L

Scenario 2: At start of year 2, expectation of loss revised to be zero at maturity

Comparison of Expected Loan Loss versus Incurred Loan Loss models

Deloitte, 2010

-20000

0

20000

40000

60000

80000

100000

120000

1 2 3 4 5

Years

$

EDImpairmentbal sheetallowance

EDImpairmentP&L

IAS39 P&L

Reform of Accounting standards

ICAEW proposals (ICAEW, 2010)- Auditors may provide assurance on new summary risk statements

of banks.

- Banks should confirm that key areas of judgement discussed with auditors are set out in critical accounting estimates of financial statements. Auditors to be involved in reporting on front sections of annual reports.

- Regular dialogue between auditors and banking supervisors.

- Supervisors should tap auditors’ expertise as part of their monitoring regime.

Sociological Perspectives of Risk Management & Control

The Risk Management of Everything (Power, 2004)

1. Rise of Internal Control – critical events: Cadbury Code in 1992 due to collapse of Maxwell Empire, COSO document in US

Internal controls turned from private organizational practices to regulatory objects e.g. Sarbanes-Oxley Act in US (turning organizations inside out)

2. Invention of Operational Risk – focus on fraud and infrastructure risk issues under Basel II; Barings case help sell the idea

- policy question of implementation effectiveness because mainly on low impact high probability (deviation from norm), not high impact, low probability events

- myth of controllability especially in areas such as management culture, “tone at the top”

Sociological Perspectives of Risk Management & Control

3. Making Risk Auditable: Legalization & Organization

pressures on organizations to manage all risks (more litigious

environment) managers of risks more concerned about protecting their own risks experts made accountable for too much uncertainties, things

they do not know dangerous flight from judgment and culture of defensiveness e.g.

debated “tick-box” mentality of auditors not exercising professional skepticism

The Risk Management of Nothing (Power, 2009) challenges the mere

use of metrics in enterprise risk management (ERM) and not recognizing

that risk appetite is dynamic organizational process involving values and

the interconnectedness of risks with external states of world.

Sociological Perspectives of Risk Management & Control

How evaluation practices of ABS/MBS and CDOs lead to

arbitrage and credit crisis (Mackenzie, 2010)

1. Historical path-dependency of evaluation practices

CDO – primary object is default

MBS – primary object is prepayment risk (3 government

sponsored agencies: Ginnie Mae, Fannie Mae, Freddie Mac seen as

backing the mortgages)

- Minimal prepayment penalty high prepayment risk

- Prepayment option reduces value of MBS

- Key skill in evaluation is on prepayment risk

Sociological Perspectives of Risk Management & Control

2. Evaluation practices oriented towards credit correlation- Influence the creation of tradable credit indices

3. Evaluation practices become different organization routines in different

parts of the same organization (banks, rating agencies)- e.g. ABS and CDO evaluated by different sections of rating

agencies; for ABS CDO, treated as variant of CDO, based on underlying ABS ratings

4. Ratings encode default probability and become rules for institutional

investors – 74% of US and 78% of European fund managers use

minimum rating buying requirement

- In US, 100 federal laws & 50 regulations incorporate ratings

Sociological Perspectives of Risk Management & Control

5. Ratings “black-boxed” complexities of complex instruments- spreads can be compared across instruments based on spread-

rating relationships- design of instruments driven by how they will be evaluated by rating

agencies

6. Different evaluation practices allow arbitrage- tranches of CDO at A, AA, AAA give higher yields than

corresponding corporate or asset-backed derivatives- default probability & recovery rate of CDO based on ABS’ ratings

and defaults- ABS correlations hard to obtain (lack of markets & defaults were

rare)- Judgment & consistency with ABS correlation, plus competition lead

to 0.3 correlation factor by S&P, Moody’s

Sociological Perspectives of Risk Management & Control

- Diversifications at ABS level and at CDO level incorporated twice in ratings

7. Traditional buyers of mezzanine (BBB rated) ABS tranches displaced by ABS CDO managers.

ABS CDO managers need to buy “raw materials” (ABS) Demand for ABS > Supply Lend to securitize Loosening of lending standards

References

1. Deloitte, 2010. IFRS 9 proposals: Accounting for financial instruments following a financial crisis.

2. Epstein, Nach, Bragg, 2008. GAAP 2009 Interpretation and Application of Generally Accepted Accounting Principles. John, Wiley & Sons, Inc.

3. Financial Stability Forum, 2009. Reporting of the Financial Stability Forum on Addressing Procyclicality in the Financial System.

4. HSBC, 2009. Annual Report. <http://www.hsbc.com.>.

5. ICAEW, 2010. Audit of Banks: Lessons From The Crisis. 6. International Accounting Standards Committee (IASC), 2009. International Accounting Standard

39.

7. MacKenzie, D., 2010. The Credit Crisis as a Problem in the Sociology of Knowledge. Working Paper.

8. Power, M., 2004. The risk management of everything. Demos publication.

9. Power, M., 2009. The risk management of nothing. Accounting, Organizations and Society 34, 849-855.

10. Ryan, S., G., 2008. Accounting in and for the Subprime Crisis. The Accounting Review 83, 1605-1638.

11. Turner, A., 2010. Financial Services Authority Chairman address to the Institute of Chartered Accountants in England and Wales (ICAEW) in London.