Download The Monetary Transmission Mechanism:Evidence from the Industry

Pro-cyclicality of accounting
standards: an overview
Paolo Angelini
Banca d’Italia
Florence, 18 September 2009
The views expressed in this presentation are
the author’s own and do not necessarily
reflect those of the Bank of Italy
Outline of presentation
1. A macro perspective: The (new) financial
accelerator. The role of leverage
2. Accounting standards: impact on procyclicality
3. Corrective actions
What is pro-cyclicality?
Financial sector pro-cyclicality: features
of the fin. system that amplify the cyclical
fluctuations of the economy
The (New) financial accelerator
• Little o no money&finance in macro models
until the late nineties
• Recent developments:
•
Kyiotaki and Moore (1997), BGG (1999):
Demand side financial frictions (the financial
accelerator)
• Current crisis is contributing to change
•
Flourish of DSGE models including supply side
financial frictions (the “new” financial accelerator;
Adrian and Shin, 2008)
The (New) financial accelerator
A
L
Loans 50
Capital 10
Shares 50
Deposits 90
100
100
Leverage =100/10=10
The (New) financial accelerator
Assume a shock to share prices:
A
L
Loans 50
Capital 5
Shares 45
Deposits 90
95
95
Leverage =95/5=19 !
The (New) financial accelerator
If operators do not adjust leverage, no
feedback:
Equilibrium
before shock
Asset
prices
New
equilibrium
Leverage
The (New) financial accelerator
If operators have leverage target, will try to
reduce leverage by selling assets / liquidating
deposits
Targeted
leverage
Asset
prices
Excessive
leverage
Leverage
The (New) financial accelerator
• Empirical evidence on this mechanism?
FINANCIAL ASSETS AND LEVERAGE IN THE US:
HOUSEHOLDS
Total
assets
growth,
%
QoQ
Leverage growth, % QoQ
Source: Adrian & Shin (2008)
FINANCIAL ASSETS AND LEVERAGE IN THE US:
COMMERCIAL BANKS
Total
assets
growth,
%
QoQ
Leverage growth, % QoQ
Source: Adrian & Shin (2008)
FINANCIAL ASSETS AND LEVERAGE IN THE US:
INVESTMENT BANKS
Total
assets
growth,
%
QoQ
Leverage growth, % QoQ
Source: Adrian & Shin (2008)
FINANCIAL ASSETS AND LEVERAGE:
MONETARY&FINANCIAL INSTITUTIONS (MFIS)
Total
assets
growth,
USA
UK
DE
FR
IT
JAP
%
QoQ
Leverage growth, % QoQ
Source: Panetta&Angelini (2009)
GDP AND LEVERAGE:
MONETARY&FINANCIAL INSTITUTIONS (MFIS)
USA
UK
GDP
growth,
DE
FR
IT
JAP
%
QoQ
Leverage growth, % QoQ
Source: Panetta&Angelini (2009)
Summing up:
•
Not obvious that NFA is at work in
normal times
 Not obvious that pro-cyclicality was
a major cause of the current crisis
•
However, NFA was clearly major
amplifier of current crisis
Factors affecting NFA/pro-cyclicality
•
•
•
Technological progress
Financial globalization (chart)
…
•
•
•
•
Capital regulation (Basel II)
Managers incentives
….
Accounting: Fair value accounting
FVA: Main innovations
1. Fair Value principle
2. Classification according to holder
intention
3. Prohibition to accumulate generic
reserves
FVA: 1. Fair Value principle
•
The amount for which an instrument “could be
exchanged between knowledgeable, willing
parties in an arm’s length transaction”
•
Level 1, 2 , 3 assets:
1. Observable market prices (mark-to-market)
2. Comparable instruments or models w/ observable inputs
3. Mark-to-model (thin or no mkt; ABS, CDOs, …)
FVA: 1. Fair Value principle
Implications for pro-cyclicality:
FVA immediately transposes asset price changes into
balance sheets
 Gains/losses feed immediately into New Financial
Accelerator
FVA: 2. Classification based on intention
Balance sheet
P&L
L&R, HTM
Amortised
cost less
impairment
Not m-to-m,
unless
impaired
AFS
Fair value
Not m-to-m,
unless
impaired
HFT, FVO
Fair value
m-to-m
FVA: 2. Classification based on intention
Implications for pro-cyclicality
Potential for increased discretionality in representing
accounting situation
 increased opacity
 reduced market liquidity when confidence
evaporates
 wider asset prices swings feed into NFA
Increased discretionality: examples
1. Mark-to-model done using proprietary models
2. Distorted use of HFT
3. Hedge accounting (detail)
2. + 3.  excessive recourse to FV valuation. At some
banks, assets in FVO+HFT exceeded 50% of total
assets, with peaks above 70%
FVA: 3. Prohibition of generic reserves
• Narrow accounting definition of expected
losses: impairment losses must be
actually incurred
• Prudential reserves eliminated
• Objective of prohibition: reduce
managers’ discretionality, enhance
accounts transparency
FVA: 3. Prohibition of generic reserves
Implications for pro-cyclicality
•
Reduced income smoothing, stronger expansion
of lending in booms and contraction in
downturns
FVA: other issues
• Treatment of liabilities
• Liabilities still largely carried at historical cost
(chart)
• Valuing liabilities at FV would clearly reduce
pro-cyclicality
• However, paradox might emerge
FVA: other issues
• Treatment of goodwill
• HCA: buyer amortizes goodwill
• FVA: goodwill is indefinite lifetime asset,
but subject to annual impairment test,
with losses affecting the P&L account
• In good times pro-cyclical M&A contribute to
expansion of balance sheets
• In bad times impairment testing causes losses on
goodwill to emerge, further depressing profits
FVA: other issues
• Treatment of risks
• HCA: risks play no role
• FVA: implicitly endorses the market estimate of
risk – a huge improvement
• However: if market prices understimate risk, so
does fair value
• Key observation: Risks tend to materialize in
downturns, but to accumulate in booms
(Borio and Lowe (2001)) (charts)
The role of FVA should not be overemphasized
• Many “mechanisms” pre-date adoption of
FVA:
• Mark-to-market of certain assets (derivatives,
traded shares)
• Haircuts, margin calls
• The underestimation of liquidity risk can hardly
be ascribed to FVA
• SIVs existed well before FVA
Possible corrective actions
Going back to historical cost accounting??
• Estimating a phenomenon based on one
observation is never good statistical practice
Kalman gain
• In principle, HCA is strictly dominated by FVA
Possible corrective actions
• Excessive recourse to FVA should be
prevented (e.g. a minimum turnover
rate/maximum holding period could be set for
the inclusion in the HFT portfolio)
• Consolidation and derecognition rules should
be improved (not a problem of FV)
The treatment of special purpose entities is decisive
in assessing leverage and hence pro-cyclicality
Possible corrective actions
• Prohibition of generic reserves: Critical
issue, at the joint between accounting
and regulation
• Solution requires agreement between
supervisors and accountants
Possible corrective actions
•
Two cornerstones of the current
system:
1. capital requirements  unexpected losses
2. provisions  expected losses
Possible corrective actions
1. Capital requirements: adopt mechanisms
which reduce pro-cyclicality while preserving
the risk measurement improvements
introduced by Basel II
•
Adjust the inputs, the output or the parameters of
the regulatory function (detail)
•
Recent proposal by CEBS: (i) replace current PDs
with downturn PDs in the regulatory function; (ii)
use outcome to set capital buffers under Pillar 2
Possible corrective actions
• CEBS proposal:
– Flexible, does not affect P&L  solves conflict
with accounting rules
– Discretionary ( opacity, level playing field
concerns), risk of regulatory forbearance in good
times
Possible corrective actions
2. Broaden the accounting concept of expected
losses, acknowledging that they increase in
good times
•
Dynamic provisioning (Spain):
Gt= Gt-1 + gt
gt = αΔLt + Lt - current losses
•
Compatibility with accounting principles?
Possible corrective actions
• Provisions/valuation reserves should not be
restricted to credit risk:
•
•
•
•
Model risk (level 2-3 assets, mark-to-model) (chart)
Illiquid assets
Maturity mismatches
New financial instruments
Latest developments
• IASB: use of FV likely not reduced
• FASB: use of FV likely increased
• Risk of divergence across the Atlantic
Financial vs trade integration
Source: Lane&Milesi-Ferretti (2007)
(back)
Fair value hierarchy
Source: Panetta&Angelini (2009)
(back)
Hedge accounting
Hedge is “highly effective”?
• Yes  both the derivative and the hedged
item (only part hedged) valued at
FV
• No  hedged item:
• entirely valued at amortized cost
• entirely valued at FV
 strong incentive to resort to
estimates and to excessively expand
share of instruments at FV
(back)
Share of Bank Assets and Liabilities
Valued at Fair Value (December 2007)
%
Source: Panetta&Angelini (2009) (back)
Ratings drift and GDP growth
Source: Panetta&Angelini (2009)
Default rates and GDP growth
Source: Panetta&Angelini (2009)
Implied volatility: 1 year euro swap rate
Source: Thomson Financial
Implied volatility: 1 year dollar swap rate
Source: Thomson Financial
Implied volatility: euro area stock market
(VSTOXX)
Source: Thomson Financial
Implied volatility: US stock market
(VIX)
Source: Thomson Financial (back)
The Basel II capital function
K
= Capital requirement
PD
= Probability of default
LGD = Loss given default

= Correlation among borrowers

= Normal c.d.f.
(back)