The only thing that is constant is change
Heraclitus, an ancient Greek philosopher who lived around 500 BC said “The only thing that is constant is change.” This quote is apt for the world of banking in the 21st century. Since the global financial crisis of 2008, there has been a significant change in the way banks conduct their business, how banks are regulated and the accounting for financial instruments.
So, the key question is: What is the impact of these changes on bank’s financial statements?
In order to understand this, let’s look at the three R’s – Regulation, Risks and Returns:
- Regulation: The changes to bank regulation as a result of the global financial crisis of 2008, has had a profound impact on how banks conduct their business. Basel III has been introduced to strengthen banks capital requirements, and also includes liquidity and leverage ratios as part of the framework. Many banks have raised large amounts of capital to meet the stringent capital ratio requirements in Basel III. IFRS 9 has been introduced to improve the accounting for financial instruments.
- Risks: The key financial risks that banks are exposed to include credit risk, liquidity risk and market risk (foreign exchange, interest rates etc.). These risks are priced into the valuations and banks often look at ways to manage and mitigate them. For example, banks constantly try to predict the next interest rate move as it directly affects the pricing of loans and other debt instruments, and ultimately the net interest income.
- Returns: The quality of asset base is crucial for banks and directly affects their profitability. The assets held in the banking book and trading book have different objectives, risks and returns. This affects the classification and measurement of the assets, and also the bank’s regulatory capital requirements. The challenge for every bank is to achieve a trade-off between profits and risks.
So, how do the three R’s affect bank’s financial statements?
New bank regulation has been introduced to fix the faults that led to the financial crisis and comes with high compliance costs. In addition, the inability to close profitable transactions due to higher regulatory capital requirements under Basel III has an impact on the profitability. For example, a profitable transaction may be rejected by the CFO as it involves holding more capital, or adversely affects leverage and/or liquidity ratios under Basel III.
With regards to financial risks, banks need to make decisions about which risks to hedge, what extent to hedge and which techniques to use to mitigate the risks. If hedging and hedge accounting are applied properly, the financial statements prepared under IFRS 9 should closely reflect the risk management activities of the bank.
There will also be a significant impact on returns and related ratios like return on assets and return on equity on transition to IFRS 9. IFRS 9 requires classification of financial assets based on the business model within which the financial assets are held and their cash flow characteristics tests. This affects subsequent measurement of the financial assets. The standard also requires earlier and timely recognition of loss allowance based on expected credit losses. This will increase the loss allowance on transition.
Whether you are an accountant, auditor, regulator or an analyst, it is important to understand the transactions, their pricing and calculations that drive the amounts recognised in bank’s income statement and balance sheet. This includes key line items like net interest income, net fees and commissions, impairment, loans and advances, deposits, derivatives, bond issues etc. In addition to these skills, an understanding of fair valuation, hedge accounting and financial instruments disclosures is essential for effective analysis of bank’s financial statements.
The implementation of IFRS 9 represents a fundamental change in approach to classification of financial assets, loss provisioning and hedge accounting. This will significantly affect the preparation, analysis and interpretation of bank’s financial statements from 2018. Banks by now need to be aware of the new principles and ensure they are on the right path to meet the implementation deadline.
This article is by Saket Modi and first appeared in http://www.iaseminars.com/latest/553_the_only_thing_that_is_constant_is_change.