AQR: What is the future – Accounting or Prudential Valuation?

Summary: The AQR treatment on accounting impairment demonstrates how important prudential valuation can be in the future if the ECB continues to use it. In this case, banks will have to consider the differences between accounting and prudential valuation to ensure an adequate and integrated capital and balance sheet management, as long as accounting impairment is based on the incurred loss model. A reliance on accounting valuation to manage the balance sheet may not suffice. 

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The three elements of the Comprehensive Assessment are the Supervisory Risk Assessment, the Asset Quality Review (AQR),  and the Stresstest. Together, these elements provide an in-depth understanding of material balance sheet risks. As economic risks are linked to balance sheet calculation, it is crucial to differentiate between the application of adequately interpreted accounting rules on one side, and the prudential adjustments required by the Comprehensive Assessment on the other side. The latter shall assure a proper and (more) harmonised calculation of the CET1 (Common Equity Tier1). Both, the identification of prudential balance sheet adjustments and the recalculation of CET1 is be part of the AQR. The AQR itself comprises three key phases:

  • portfolio selection: result- identification of exposures with the highest risk and portfolios which should be included in the execution phase; status: completed
  • execution: result:-identification of prudential balance sheet adjustments ; status: on-going
  • collation: result- AQR adjustment calculation to CET1; status: scheduled for July 2014

With respect to the close relation between accounting and prudential valuation it is important to note that the “AQR should not be seen as an attempt to introduce greater prescription into the accounting rules outside of the existing mechanisms.” Among others, the following questions arise:

Impact of the prudential AQR valuation adjustments on bank accounting: The ECB states that “Banks would not be expected to incorporate into policies, processes or reporting findings from the AQR that relate to a bank failing to be the right side of the ECB threshold if they are compliant with the relevant accounting principles. The bank would not be required to restate accounts or apply the AQR assumptions on an on-going basis, i.e. the AQR-adjusted CET1% is not a de- facto alternative accounting standard.”

Treatment of prudential adjustments on accounting valuation in the course of the Comprehensive Assessment: “The AQR will generate a series of parameters that will act as inputs to the stress test process. The key inputs to the stress test will be: any adjustments to data segmentation highlighted by DIV, an AQR-adjusted Common Equity Tier 1% (CET1%) parameter (to allow the impact of the AQR to be applied to stress test projections of the CET1%) and probability of Impairment (PI) and Loss Given Impairment (LGI) parameters for use in the stress test. The way these parameters will be used in the stress test is pending the final methodology for the stress test, which is currently underway. As mentioned, the AQR-adjusted CET1% will be used to compute the final stress test outcomes.” One follow-up action of the ECB can be, however, to ask banks to capitalise for a shortfall relative to the ECB threshold in incremental Pillar 2 capital requirements.

Consequences if the ECB concludes that the accounting rules used by the bank are not in line with best practice interpretations: Following completion of the Comprehensive Assessment, “NCAs will produce a letter to significant banks outlining any areas where the bank is found to be outside of accounting principles and the required remediation actions the bank would be expected to take (including adjustments to the carrying values of assets). These issues would be expected to lead to adjustments to available capital and hence be reflected in Pillar 1 capital requirements at the next relevant reporting date. For the purposes of clarity,  areas where the bank falls short of the “ECB threshold” but is in line with accounting standards would not be included in the letter to the bank.”

The  case of prudential impairment calculationIAS 39, Para 59 (EU) states: “A financial asset […] is impaired and impairment losses are incurred if, and only if, there is objective evidence of impairment as a result of one or more events that occurred after the initial recognition of the asset (a ‘loss event’) and that loss event (or events) has an impact on the estimated future cash flows of the financial asset […] that can be reliably estimated. It may not be possible to identify a single, discrete event that caused the impairment. Rather the combined effect of several events may have caused the impairment. Losses expected as a result of future events, no matter how likely, are not recognised. […]” The ECB defines the following approach in its AQR-Phase2-Manual: “Initially, the NCA bank team will compare the impairment triggers of the significant bank as of December 31st with the minimum triggers provided in Table 38 of the manual and the loss events stipulated IAS 39. Where the significant bank has defined additional or more conservative triggers, these should also be taken into consideration in addition to the minimum triggers. This implies that the evidence of impairment definition is at least as conservative as the significant bank’s current classification.The NCA bank team should assess each exposure in the sample for objective evidence of impairment on December 31st 2013. This requires a two-step approach:

  • First, assessment for each exposure whether a loss event has happened based on the triggers provided. Not all of the triggers apply to each debtor (e.g. CDS is not relevant for retail mortgages or large SME).
  • Second, for each exposure with a loss event, the assessment whether the loss event has an “impact on the estimated future cash flows” of the exposure. If this is the case, the exposure will be considered as having evidence of impairment.“

In contrast to the above mentioned criteria, current or past cash flows do not necessarily need to be impacted for an exposure to be considered impaired according to IAS 39. Additionally “NCA bank teams will classify exposures as having evidence of impairment irrespective of whether the impacted future cash flows indicate that an impairment loss should be registered (i.e. impaired loans where impairment loss is assessed as 0 due to collateral should be viewed as being impaired because cash flows will be impacted by the foreclosure of collateral).”

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