Financial Stability and Financial Reporting Learning from the ...

Financial Stability and Financial ReportingLearning from the Crisis - Rebuilding Trust

Bucharest, 29 June 2009

John HegartyHead, World Bank Centre for Financial Reporting Reform

Financial Stability and Financial Reporting

Presentation outline

» Global impact of a global crisis» Some Europe and Central Asia (ECA) specificities

» Causes of the crisis» Policy response

» International» European

» Consequences for financial reporting» Recent developments» Ongoing initiatives

» Concluding remarks


Impact of the global financial crisis» 2009 will be a dangerous year. The World Bank predicts that global GDP will

contract by 3%, which would be the first decline in world output since World War II.» Global trade is expected to fall in 2009. The first time in 27 years.» Investment growth in the developing world is projected to fall from 13% in 2007

to 3.5% in 2009.» GDP growth in the developing world will slow to a projected 2.1% in 2009, from

5.8% in 2008. » Net private capital flows to developing countries could be more than $700 billion

lower in 2009 compared with 2007.» Up to 90 million more people are being trapped in extreme poverty (< $2/day) in

developing countries. This follows on from the 155 million more in 2008, because of the food and fuel crises. The number of chronically hungry is projected to climb to over one billion this year.

» Infant mortality rates are set to soar. Between 2009 and 2015, a total of 1.4 to 2.8 million more infants may die if the crisis persists.

» Almost 40% of 107 developing countries are highly exposed to the poverty effects of the crisis. Less than 10% face little risk. Three quarters of these countries cannot raise funds domestically or internationally to finance programs to curb the effects of the downturn.


The slowdown is sharpest in ECA

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CEE CIS East Asia Latin America

2007 2009p

GDP growth (annual percent change)

Growth is expected to fall more than in other emerging regions


ECA relied a lot on external borrowing

Capital Flows to EMEs (Average 2005-07, in percent of GDP)

ECA’s reliance on foreign finance is not unique, what is unique is its dependence on loans for banks and corporates - very little foreign equity portfolio investment

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Many ECA countries have foreign bank ownership which has brought benefitsBanks in Central, Eastern and South East Europe are generally foreign owned

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Foreign banks share in total banking sector assets (in %; end-2007)


…and should stay financially integratedFinancial market linkages which channeled prosperity to the region over the last decade must be kept open during the crisis

Parent-daughter links are likely to be stronger than other private flowsThree Examples of Dependence on Western European Banks

Source: Zsofia Arvai, Karl Driessen, and Inci Otker Robe, 2009, "Regional Financial Interlinkages and Financial Contagion within Europe," IMF, WP/09/06; BIS data at end-2007


ECA – What we should do» Fiscal policy options are limited • Most countries do not have space for fiscal stimulus programs• Possible exceptions are some middle-income CIS economies such as

Russia and Kazakhstan• Some room to let automatic stabilizers work» Social policy actions are a priority• Region has started to give back poverty gains of the last decade• Most countries in the region have social programs that can be strengthened

and scaled up to provide targeted assistance• Especially needed in low-income CIS economies such as Tajikistan and

Moldova, but these countries not well equipped » Financial policy measures are necessary

• To stabilize banking systems, not individual banks• Especially for economies with strong financial ties to western banks

such as the new EU Member States• Strengthen effective implementation of the acquis communautaire


Causes of the global financial crisis

At the root of market failure was optimism bred by a long period of high growth, low real interest rates and volatility, and policy failures in:

» Financial regulation, which was not equipped to see the risk concentrations and flawed incentives behind the financial innovation boom

» Macroeconomic policies, which did not take into account the build-up of systemic risks in the financial system and the housing markets

» The global financial architecture, where a fragmented surveillance system compounded the inability to see growing vulnerabilities and links

Implications for financial reporting


Financial regulationSimilar activities conducted by various types of institutions were regulated differently, even when in a single group and subject to the same regulator. The resulting opportunities for regulatory arbitrage fuelled the growth of the shadow banking system, resulting in excess leverage obscured by complexity.

» Information gaps in data and the understanding of underlying risks» Procyclicality (prudential regulation, compensation, fair value accounting, provisioning)» Failures of market discipline, corporate governance, risk screening and due diligence

(originate-and-distribute, CRAs, off-balance-sheet vehicles, etc. – from an ownership society to a failed agency society)

» Regulation and supervision too firm-centric to see through to the systemic risk


Macroeconomic policiesMacroeconomic and financial stability issues were generally treated separately, rather than taking an integrated macro-prudential approach, the former focused on preserving low and stable inflation as well as growth, the latter on firm-level supervision of the formal banking sector. Neither set of policymakers saw the wider implications of rising risks in the shadow financial sector; nor did they appreciate that economy-wide trends in credit growth, leverage and house prices posed systemically costly tail risks.

» Central bank reliance on prudential regulation to control build-up of systemic risk» Financial reporting firm-level rather than systemically-focused


Global architectureThis crisis was a story of fragmented surveillance in silos of expertise; of a policy debate dispersed in numerous fora (BIS, Gs, FSF, IMF); of limited collaboration among national financial regulators; of ad-hoc bilateral, regional, and multilateral facilities to address financing and liquidity needs; and of an overall failure to engage key decision-makers around the world.

» Surveillance: Monitoring threats to external stability, whether they stem from shocks, policies, exchange rates, capital flows, or data deficiencies

• Warnings too scattered and unspecific• No suggestion of dire macroeconomic consequences

» Multilateral coordination: The institutional arrangements for policy action• Machinery and commitment for coordinated actions inadequate (e.g. global imbalances)• “My-country-first” initial policy responses

» Financial regulation: Best practices for financial oversight and ground rules for collaboration on cross-border financial institutions

• Different thresholds for intervention, different materiality of risks, different resolution tools• No ex ante rules governing cross-border resolution or burden-sharing

» Financing: Official resources to meet liquidity or adjustment needs» Accounting and auditing standard-setters not sufficiently “plugged-in”


Proposed solutions (IMF, February) » Ensuring that prudential regimes encourage incentives that support systemic

stability and discourage regulatory arbitrage, and assure effective enforcement of regulation

» Addressing the procyclicality of existing capital requirements and other prudential norms, preferably in a manner that is rules based and counters the cycle

» Filling the information gaps, especially with regard to lightly regulated financial institutions and ‘off balance sheet’ transactions, ensuring that both supervisors and investors are provided more disclosure and a higher level of granularity in information provided


G20 Summit – London, 2 AprilImportance of the G20, rather than G7 or G8

» Restore confidence, growth, and jobs » Repair the financial system to restore lending » Strengthen financial regulation to rebuild trust» Fund and reform the international financial institutions to overcome this crisis

and prevent future ones » Promote global trade and investment and reject protectionism, to underpin

prosperity» Build an inclusive, green, and sustainable recovery


G20 Declaration: Strengthening the Financial System

» Accounting standard setters to work urgently with supervisors and regulators to improve standards on valuation and provisioning and achieve a single set of high-quality global accounting standards

» Take action, once recovery is assured, to improve the quality, quantity, and international consistency of capital in the banking system. In future, regulation must prevent excessive leverage and require buffers of resources to be built up in good times


De Larosière Report (EU, February)» A new regulatory agenda

• Reduce risk and improve risk management• Improve systemic shock absorbers• Weaken pro-cyclical amplifiers• Strengthen transparency• Get the incentives in financial markets right

» Stronger coordinated supervision• Macro-prudential and micro-prudential• Build on existing structures• Stronger, coordinated supervision for all financial sectors in the EU• Equivalent standards for all, to preserve fair competition in the single market

» Effective crisis management procedures• Build confidence and trust among supervisors• Agreed methods and criteria


De Larosière Report – Recommendations

» Reform of accounting rules and standard-setting processes» Develop a truly harmonized set of core rules for financial markets and

stability in the EU» Fundamental review of Basel 2 rules» Common EU definition of regulatory capital


A new European Framework for Safeguarding Financial Stability


The Need for a Strengthened International Financial Architecture

1990s – Emerging market crises and contagion effects

East Asia (Thailand)

Philippines

Malaysia

Hong Kong

Indonesia

Taiwan

South Korea


The Need for a Strengthened International Financial Architecture

2000s – Developed market crises and contagion effects

The persistent and global challenge of ensuring high quality corporate governance and financial reporting –this is neither a regional nor a one-time problem


Financial reporting A fundamental foundation

Securities Regulation

Banking Supervision

Accounting & Auditing

Corporate Governance

Insurance Supervision

Insolvency & Creditor Rights


Importance of high quality financial reporting

Accounting and

Auditing

Development of Capital Markets

Job Creation

Financial Stability

Private Sector Growth

Financial Sector Development

Improved Access to Credit

Financial Information

ECONOMIC GROWTH


The simple logic

“No transparency, no trust; no trust, no credit; no credit, no investment; no investment, no growth!

So there is a simple logic: financial reporting is an essential building block for financial intermediation, foreign investment, and sustainable economic development.”

Martin GruellRaiffeisen International


Importance of the financial reporting infrastructure, not just accounting and

auditing standards

Statutory & Governance Framework

Monitoring & Enforcement

Education & Training

Accounting Profession &

Ethics

Accounting Standards

Auditing Standards


All supporting pillars need to be strengthened

Statutory & Governance Framework

Monitoring & Enforcement

Education & Training

Accounting Profession &

Ethics

Accounting Standards

Auditing Standards


Lessons learned for financial reporting» Market discipline didn’t work

» Serious questions about the agency model. Need to move to a “fiduciary society”?» Prudential supervision (micro and macro) has an indispensible role» Why should markets and regulators want different information? Who knows best?

» Even if it didn’t cause it, financial reporting facilitated procyclicality » Financial reporting is not neutral – hard-wired into regulatory systems, contracts, incentives» Accounting and auditing are designed for stable systems - need to take better account of the

business cycle, and to have circuit-breakers in times of severe stress» The current mixed-attribute model is not functional; risks not understood or reflected

» Standard-setters underestimated their systemic role » Political frustration with the IASB» IFAC’s PIACs (IAASB and IESBA) not central

» Where were the auditors? » Why did the audit function as designed make so little difference? Where’s the value-added?» Can audit reporting be expanded beyond the micro only?» Should the profession not have spoken out more and earlier about the weaknesses in the

accounting and auditing model?


Possible impacts on financial reporting» Rebalancing the priorities of financial reporting

» Treating financial institutions differently – who are the real bearers of residual risk?» Less emphasis on market discipline and neutrality – more on prudential stability concerns and

on the role of financial reporting in shaping behaviors (de jure and de facto)» Continuing the push to go beyond the single earnings figure – things are more complicated» Consolidation, fair value, reserves and provisions, risk disclosures, goodwill, deferred tax, taking

account of the macro » “Traditional IFRS” for only non-financial PIEs? What about the IFRS for SMEs?

» Continuing pressure for further reforms of the IASB » Greater integration with, and accountability to, the broader global system of financial regulation:

traditional “independence” an unhelpful concept» Increased EU influence unless the US proceeds urgently with the SEC roadmap» Recognition of the prudential and other impacts of financial reporting

» Trying to work out how the audit function fits in the new landscape » Beyond the “pure” financial statement audit» Can audit reporting be expanded beyond the micro only?» Expanded links between the auditor and prudential regulators» Better integration of the IFAC PIACs with, and accountability to, the broader global system of

financial regulation – building on the earlier IFAC reforms, Monitoring Group assessment


IASB, IAASB, and IESBA activities» IASB

» SEC Roadmap and Convergence Project in doubt. IFRS and US GAAP to co-exist indefinitely?» Governance reforms ongoing. More fundamental changes may be needed» Changes to fair value standards under severe political pressure and abbreviated due process» Work underway to revamp approach to fair value. Will the EU be satisfied?» Degree of EU support for IASB/IFRS uncertain. Risk of further carve-outs/ins.» IFRS for SMEs about to be issued, but likely take-up uncertain

» IAASB » ISA Clarity Project completed» EU endorsement likely. Consultations underway» Future focus on implementation» But does the audit model need to change?» Significant reduction in scope of application of statutory audit planned for the EU

» IESBA » Revised Code of Ethics about to be issued, with significant changes in independence section» Challenges of acceptance – not at same level as ISA


Strength of the EU acquis» Force of law, due process, legitimacy» Based on recognition that high quality corporate governance and financial

reporting are an essential underpinning for cohesion and competitiveness in the Single Market

» Comprehensive coverage of all pillars of the governance and reporting infrastructure

» Integration with other aspects of regulation» Europe in a global context – international standards and relations with third

countries» But … the challenges of implementation:

» Strengthening of institutional and human capacity required for effective implementation and enforcement

» The acquis is a moving target, tight deadlines


European Commissioner McCreevy

Sound financial reporting is an essential condition for market economies to work properly. Improving the quality, comparability and transparency of the financial information is crucial for the Internal Market, as well as for strengthening economic links between the EU, candidate and potential candidate countries, and other third countries.

I am delighted to have been invited to the opening of the World Bank Centre for Financial Reporting Reform here in Vienna. This is an important milestone in the work of the World Bank and emphasizes its commitment to strengthening financial reporting standards in Europe and Central Asia. I am also convinced that the opening of this office will further strengthen the excellent cooperation between our institutions.

We have come a long way in our work towards creating an appropriate framework for financial reporting and auditing, but there is more to be done. This goes for national implementation, as well as our joint efforts to come to global financial standards. We are thankful for the commitment of the World Bank to support countries in their moves towards closer integration with the EU and towards better financial reporting.

We very much welcome the contribution of the World Bank to promote the use of international standards on auditing in the Member States that joined the European Union after 2004. The work of the World Bank greatly contributes to the effective implementation and enforcement of the EU acquis, in particular with respect to public oversight and external quality assurance systems.


Concluding remarks

www.worldbank.org/cfrr

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