REPARIS – A REGIONAL PROGRAM

THE ROAD TO EUROPE: PROGRAM OF ACCOUNTING REFORM AND INSTITUTIONAL STRENGTHENING (REPARIS)

Technical Update for Banking and Insurance Regulators Overview on Institutional Developments

IFRS Seminar Series for Regulators GDLN 15 December 2010

Overview and institutional developments

!   New Chair (Hans Hoogervorst) and Vice Chair (Ian Mackintosh) at the IASB

!   Two key areas for today: Financial Instruments (IFRS 9) and Insurance Contracts (IFRS 4 phase II)

!   Interaction with regulatory developments !   Convergence of IFRS and US GAAP still on the table -  Valuation of financial instruments at the centre of the

debate -  Valuation of financial instruments have an impact

on….regulatory capital !   SEC will decide by the end of next year whether to allow

US firms to use IFRS. Their decision will partly depend on the “independence of the IASB”

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Overview and institutional developments

!   Convergence with US GAAP - Work started in 2002 between IASB and FASB -  Common set of high quality standards - Memorandum of Understanding -  Specific milestones in 2006 -  In 2008, MoU updated

•  Series of priorities and milestones to complete remaining major joint projects by 2011

•  Pressure from G20 to complete convergence •  In 2010 modified the convergence strategy to focus on

priorities •  June 2011 target for high priority project •  Later date for other projects which need more research

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Overview and institutional developments

!   Convergence on financial instruments remains an obstacle !   FASB going for full fair value, even for loans !   IASB do not favour fair value of loans !   Different approaches re. financial instruments would have an

impact on risk weighted assets and amount of available capital: Different capital ratios

!   So there is a direct link between accounting of financial instruments and regulatory capital

!   Argument to have loans at cost is because there is no price to fair value and also banks tend to keep loans in their books for the long term

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Overview and institutional developments

!   Very recent decision : re-exposure of an exposure draft on impairment

!   When to recognise the losses: upfront or over the life of the financial

instrument -  FASB for instance has a preference for recognising the losses upfront -  IASB preference is over the life of the financial instrument -  They are also exploring the possibility of an accelerated recognition of

the losses

!   The use of good book (expected loss) v/s bad book (incurred loss)

!   The financial instrument is transferred to the bad book where expected losses are recognised

!   The question is which financial instruments to transfer, ie what is the trigger point

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Overview and institutional developments

!   There are many ideas (sometimes conflicting) from various stakeholders: regulators, industry, other organisations…

!   The challenge is to bring them together but sometimes its not possible

!   The aim is also to have an accounting standard that takes into account how the banks operate

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Overview and institutional developments

!   Crucial phase for Solvency II: Implementation phase

!   It can be very complex for some firms and jurisdictions

!   For jurisdictions not captured by Solvency II but interested to know more there are different means to be updated: -  CEIOPS website -  EU Commission of level 1 Directive -  Also, some IAIS standards try to follow the spirit of

Solvency II at a high level

!   New regulatory architecture 7

REPARIS – A REGIONAL PROGRAM

THE ROAD TO EUROPE: PROGRAM OF ACCOUNTING REFORM AND INSTITUTIONAL STRENGTHENING (REPARIS)

Technical Update for Banking and Insurance Regulators IFRS 9 and Basel III

IFRS Seminar Series for Regulators GDLN 15 December 2010

IFRS 9 – Timeline and 3 Phases

!   Split the project of replacing IAS 39 into three phases - Once completed each phase will be incorporated into

a new financial instruments accounting standard, IFRS 9 Financial instruments -  IAS 39 will have been replaced in its entirety once the

third and final stage of the project has been completed

!   Phase I - classification and measurement, completed but not endorsed in the EU

!   Phase II – impairment of financial assets, ongoing !   Phase III – hedge accounting, ongoing

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IFRS 9 – Timeline and 3 Phases

!   Still work in progress

!   FASB approach is more FV

!   The first phase of IFRS 9 was introduced with an effective date of January 2013 with early application permitted

!   Key dates -  Impairment ED Q1 2011?; IFRS Q2 2011? - Offsetting and hedging IFRS Q2 2011? -  EU endorsement?

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IFRS 9 Key Issues - Classification

!   Entities business model for managing + contractual cash-flow characteristics = Amortised costs

!   (FVO is allowed when there is accounting mismatch) and

only one impairment method

!   All other instruments are at FV (equities, derivatives and some hybrid contracts) -  No impairment - OCI presentations available for equities

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Amortised Costs – Business Model

!   Business model - Objective of holding instruments to collect or pay

contractual cash-flows rather than to sell prior to contractual maturity to realise fair value changes -  Not an instrument by instrument approach to

classification

!   No “tainting” rules - Gains or losses from derecognising such items to be

presented separately with additional disclosures

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Amortised Costs – Cash-Flow Characteristics

!   Contractual cash flows that give rise to:

- Principal

-  Interest

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Financial Liabilities

!   Targeted change to address “own credit risk”

!   Retain IAS 39 measurement requirements for financial liabilities -  Held for trading - FV through P&L -  Hybrid liabilities - bifurcation requirements in IAS 39 -  “Vanilla liabilities” – amortised cost -  Maintain FVO (with current eligibility conditions)

!   Separate out “own credit risk” for FVO

!   “Own credit risk” portion separated in a manner similar to that used IFRS 7 for disclosure 14

Items still to be Discussed

!   Expected losses -  How to spread (upfront or over the lifetime of the

instrument)

- Which expected losses? All over the lifetime or shorter period?

-  How are changes in loss estimates treated? – full catch-up in P&L; partial catch up in P&L;

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Some Practical Issues on IFRS 9

!   IFRS 9 more principles based than IAS 39 !   IAS 39 was very prescriptive hence the complexity !   So implications for auditors too re. IFRS 9 !   Although still work in progress: banks (and regulators)

should to the extent possible identify material impact on balance sheet and P&L

!   Do banks have the right resources to deal with the changes?

!   Principles-based standards can be difficult to apply in a consistent manner, so comparison across banks could be more difficult

!   Impact on regulatory capital and interaction with Basel III

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!   Many regulatory reform

!   Lots of interested parties

!   Main issues are: - Quality of capital -  Excessive leverage -  Capital buffers to be maintained -  Calibration and risk coverage -  Insufficient liquidity

Overview – Basel III

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Many Interested Parties

!   G20 !   FSB !   IASB !   BCBS !   Central banks !   EU Commission !   CEBS !   US institutions

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High Level Impact

!   Based on many studies from different stakeholders:

-  Risk weighted assets: increase 0-100%

-  Common equity: decrease due to deduction: changes 10-60%

-  Common equity (Core Tier 1): ratio increase x 3

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Two Key Issues

!   Capital requirements -  Capital

•  Basel I-1988 •  Basel II -2007 (in the EU: Capital Requirements

Directive-CRD) !   Liquidity issues

-  Firms must hold adequate financial resources on capital and liquidity

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Liquidity

!   Not in Basel I or in Basel II and no international standards

!   Basel III has proposed two new minimum requirements for liquidity (not capital) -  Liquidity coverage (LC)-short term -  Net stable funding ratio (NSFR)-long term

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Objectives of Basel III Reforms

!   “…strengthen global capital and liquidity

regulations with the goal of promoting a more resilient banking sector.”

!   “…improve the banking sector’s ability to absorb shocks arising from financial and economic stress…”

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Basel III-Structure of the reform proposals

!   Capital Reform -  Quality, consistency and transparency of capital base -  Capture all risks -  Control leverage -  Buffers (including countercyclical)

!   Liquidity standards -  LC and NSFR

!   Systemic risk and interconnectedness -  Capital incentives for using Credit Counterparts (CCPs) -  Higher capital for derivatives -  Higher capital for inter-financial exposures -  Contingent capital (Coco’s) -  Capital surcharge for systemic banks (“too big to fail”)

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Key dates

!   July 2009 - Enhancements to the Basel II framework

!   December 2009 – Proposal of key components of Basel III (liquidity, capital, etc)

!   July 2010 - Counter-cyclical capital proposal and agreements of Dec 2009 proposal

!   Sept 2010- Endorsement by group of Governors and heads of supervision of July agreement

!   Dec 2010- Finalisation???

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REPARIS – A REGIONAL PROGRAM

THE ROAD TO EUROPE: PROGRAM OF ACCOUNTING REFORM AND INSTITUTIONAL STRENGTHENING (REPARIS)

Technical Update for Banking and Insurance Regulators IFRS 4 and Solvency 2

IFRS Seminar Series for Regulators GDLN 15 December 2010

Insurance accounting and Solvency II

!   Exposure draft on IFRS 4 Phase II Insurance Contracts published in July 2010

!   There are important areas which are insufficiently clear and other areas where significant additional work is required

!   The objective is to have a new accounting standard by June 2011

!   Solvency II developments are reaching a critical stage

!   Focus is now on Level 2 implementing measures

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Insurance accounting and Solvency II

!   Project has been going on for a number of years !   Too long for many people !   Still no guarantee of an accounting standard despite the

publication of the exposure draft !   Discussion paper published in 2007 !   Many stakeholders are very keen to have the phase II

finalised !   This is because they feel that the discussions have been

going on for too long !   The other concern is that there will be new members on the

board of the IASB soon !   Stakeholders fear that some debates could be re-opened and

this could create new delays

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Insurance accounting and Solvency II

!   IFRS 4 phase 1: a principles-based framework that allows a high degree of discretion

!   No consistency or transparency in the level of conservatism in estimates – IFRS 4 Phase 1 prohibits further increasing the level of conservatism in reserving, but does not require that a “best estimate” is used

!   Phase II – Exposure draft are in line with expectations but unclear on unbundling and discretionary participating contracts

!   Lack of clarity is also partly due to different approaches favoured by IASB and FASB 28

Insurance accounting and Solvency II

!   Phase 2 and Solvency II have different objectives but insurers have to address similar questions and issues regarding their implementation

!   The calculation of the core components of an insurance liability can be carried out using similar bases and models, with the possibility to develop adjustments that would reflect the differences between the accounting and regulatory valuations

!   e.g. there is overlap re. the use of unbiased cash flow estimates (building block 1) and use of observable market interest rates to calculate (building block 2)

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Insurance accounting and Solvency II

!   IFRS 4 -  IFRS 4 phase II exposure draft comment period is

over -  Final standard is expected in June 2011 -  Effective from 1/1/2013 with earliest implementation

possible

!   Solvency II -  level 2 implementing measures to be finalised this

year -  Level 3 guidance in 2011 -  Currently in the implementation phase - Go live October 2012

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Insurance accounting phase II – Application issues

!   Principles-based standard !   Discount rate !   Fulfilment cash-flows –moving away from fair value but

more reflective of how the insurance liabilities are managed

!   Portfolio approach versus insurance contract approach -  Should not affect the outcome -  Should be in application guidance -  Definition of portfolio is too broad

!   Acquisition costs -  Should be directly related to the contracts

!   Value of an insurance contract should be independent of value of the assets backing the liabilities

!   Value of insurance liabilities should not take into account the value of own credit risk

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!   Definition of contract boundaries

- Where to draw the line between and existing insurance contract and a new contract -  Participating contracts: not clear how participants

contracts should be included in the valuation of the insurance contracts -  Participating contracts features should be included but

applications could be challenging

Insurance accounting phase II – Application issues

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Insurance accounting and Solvency II

!   Similar approaches between Phase II and Solvency II -  All in scope liabilities same model -  Use current assumption -  No “conservatism” -  Use of building blocks (Best estimate, discount rate

and margin) -  Expected value

!   Some differences between phase II and Solvency II -  Residual margin in Phase II but not in Solvency II -  Calibrations could also be different

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Insurance accounting and Solvency 2

!   Valuation of assets - Phase II

•  Fair value and amortised cost depending on type of investments use of …..

- Solvency II •  Regulatory basis •  Based on IFRS with some adjustments to valuation •  Most assets on fair value •  No goodwill and few intangibles

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Next Steps

!   Please let us know which specific topics you would like to be covered in the next seminars: -  IAS 39 -  IFRS 9 -  IFRS 7 - Basel III

Key issues on - Pillar 3 for banks -  Insurance accounting phase II / Solvency II -

Valuation - Public disclosures and reporting in Solvency II

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