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The Resource for the Global Finance Profession

Three Wishes: Basel gets tough on banks to combat systemic risk

  • By Salome J. Tinker, CPA
  • Published: 2010-11-16

The guidance for reserving funds for loss contingencies offers little assistance to troubled banks—as many learned in September 2008. Loan and lease losses are taken on losses that are probable and reasonably estimable at the balance sheet date. As a result, even though the writing was on the wall that their reserves were not enough to absorb massive losses that were about to occur, banks were prohibited from adding reserves in accordance with Generally Accepted Accounting Principles (GAAP). In fact, many received SEC comment letters requiring them to reduce the reserves based on directional inconsistencies in the trend of their decreasing loss rates to their increasing reserves to be in compliance with GAAP.

Regulators, in an effort to end Regulatory Accounting Practice (RAP) vs. GAAP differences, tried unsuccessfully to sway FASB to lessen the strict rules for setting reserves. To its credit, FASB admitted that accounting standards share some, but not all, of the blame for the financial collapse of September 2008. FASB revisited its guidance on the issues seen to lead to the financial downturn, including fair value and loss contingencies. However, in its recent exposure draft about financial instruments, FASB fell short of recanting the use of the current incurred loss model for determining the allowance. This move will not only maintain the status quo for setting reserves, but will also create further divergence from the International Accounting Standards Board (ISAB), which is proposing to move toward an expected loss model that will allow forward-looking projections be factored into the calculation.

FASB's proposal also forced the bank regulators to respond. In September, the Basel Committee of Banking Supervision issued new minimal capital standards titled "Basel III." The group consists of the heads of supervision and central bank governors from countries such as Australia, Belgium, Brazil, China, Canada, France, Germany, Japan and Russia. The United States also is a member.

Bank regulators deem Basel III as a radical overhaul of global capital standards—but it still might not be enough. Jaime Curuana, general manager of the Bank for International Settlements, the overseer of the Basel Committee, indicated in a speech that despite this major step toward reform, there is still more work to be done . "Basel III is a key part, but not the only part, of the much wider agenda coordinated by the Financial Stability Board to build a safer financial system and ensure its resilience to periods of stress," he said.

The implementation of Basel III by banks will:

  • Redefine the criteria for items that can be included in Tier 1 capital.
  • Increase banks' minimum common equity requirements from 2 to 4.5 percent. This will be done in phases ending January 2015.
  • Increase the Tier 1 capital requirement, which includes common equity and other qualifying financial instruments 4 to 6 percent phased in over the same period as the common equity requirements.
  • Require banks to hold an additional capital conservation buffer of 2.5 percent to absorb losses during future periods of financial and economic stress. This will bring the total common equity requirements to 7 percent. This buffer will be phased in between 2016 and 2018.
  • Require a countercyclical, or credit, buffer of common equity of 0 to 2.5 percent. The purpose of this buffer is to protect the banking sector from periods of excess aggregate credit growth. It will only be implemented on top of the conservation buffer when there is excess growth within a country resulting in a system-wide build up of risk.
  • Create a new non-risk based leverage ratio that will serve as a backstop to the risk-based measures describe above.

Basel III's impact on corporates

While the Basel Committee firmly believes that the end result may lead to an overall strengthening of the financial markets and reduce systemic risk, in the short term these rules may cause further tightening of credit at a time when companies need the support of the banking system to get through these challenging times. Prior to issuing this new guidance, the Basel Committee conducted a comprehensive quantitative impact study, which indicated that as of the end of 2009, large banks will probably need a significant amount of additional capital to meet these new Basel requirements. Thus, companies may see a tightening of credit from these institutions as they begin to build up the required capital. Surprisingly, the study also showed that many smaller banks already meet the more stringent requirements. Thus, AFP members should not see much of an impact on the extension of credit for these smaller institutions.

Impact on reporting

Admittedly, the crisis has now gotten the banking regulators and IASB on the same accord. This financial crisis has certainly proven that the current model for reserving for loss contingencies is broken. Strangely, FASB appears to still be dancing to a different beat. It is the outlier on this issue with its position to keep with the status quo and continue to require that the expected loss model be used to determine contingent losses.

It is puzzling why FASB cannot obtain convergence on this issue. But in the organization's defense, the deliberations are still ongoing. The final standard has not been issued, so FASB could still change its current direction. AFP will be watching this issue closely.

Copyright © 2014 Association for Financial Professionals, Inc.
All rights reserved.

Copyright © 2014 Association for Financial Professionals, Inc. - All rights reserved.
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