Assessing the Disconnection Between Banks Financial and Regulatory Reporting Paper by P Klumpes

1 | The ICFR Discussion Paper

Never the Twain Shall Meet?

Assessing the Disconnection between Banks’ Financial and Regulatory Reporting

Financial Reporting: Fit for Purpose?

The ICFR Discussion Paper

Paul Klumpes Professor of Accounting, EDHEC Business School

Peter Welch Independent Banking Consultant


Note: the contents of this discussion paper are the personal views of the authors and do not necessarily reflect those of ICFR or EDHEC.

Executive Summary

This paper reviews the arguments for and against the decoupling of capital ratio calculations based on IFRS from those based on Basel II. We analyse recent trends in both accounting and regulatory supervision after the financial crisis and identify areas where there are still deficiencies in the transparency of IFRS-based financial reports and regulatory-based capital disclosures and calculations. We find that the variation in disclosure practices across IFRS and BIS-based capital estimations is significant for a sample of major European banks. We also identify how, for a large Swiss bank, variations in IFRS asset and capital bases for capital ratio calculations can make disclosures more transparent. We find evidence that the extent of variation between regulatory-based capital and IFRS-based capital is related to the size of the bank, the extent of off-balance-sheet activities and subordinated debt, the net interest margin, return on assets, value added, and productivity per employee. Variation in disclosure of the leverage ratio is related to bank size, subordinated debt exposure, return on assets, and cost efficiency. We recommend that banks enhance the scope and nature of the reconciliation of IFRS to BIS-based capital ratios to improve the efficiency of markets in reducing information asymmetry about these variations.

Keywords: BIS capital, IFRS, capital ratios, leverage ratios, reconciliation


Terms of Reference

Financial statements need to be articulated better with regulatory reporting (Basel pillar-3 disclosures, calculation of accounting and regulatory capital ratios, articulation of balance sheet and risk-weighted assets, relationship between IASB debate on incurred loss/ expected loss model for provisioning with role of expected losses in Basel framework, etc.), particularly given the extent to which investors, regulators, and other stakeholders rely on both accounting (e.g., return on equity, loan loss ratios) and regulatory (Basel capital ratios) data and performance measures.

Disclaimer We have tried to ensure that the analysis is up to date and current as of regulatory developments to the end of 2010, although the regulatory environment is changing fast. The authors believe that the research done in this paper is entirely original and draws only on data and analysis sources that are based on databases and are made only by reference to documents by third parties which, to the best of our knowledge, are freely available in the public domain. Nor have we, to the best of our knowledge, cited sources outside the publicdomain and which require prior approval from those parties. No offence is intended of any organisation mentioned as part of this research. All errors are our own. Please contact Paul Klumpes if you require more information.

Acknowledgements We appreciate the financial support given this project by ICFR. We thank Professor Philippe Foulquier, director of the EDHEC Financial Analysis and Accounting Research Centre, for his comments. Unfortunately, one of the authors of this paper, Peter Welch, died an untimely death before it could be published. This position paper is therefore a testament to his continuing efforts to shed light on shady disclosure practices in the banking industry.

Introduction to Basel II

“The Committee is aware that interactions between regulatory and accounting approaches at both the national and international level can have significant consequences for the comparability of the resulting measures of capital adequacy and for the costs associated with the implementation of these approaches. The Committee believes that its decisions with respect to unexpected and expected losses represent a major step forward in this regard. The Committee and its members intend to continue playing a pro-active role in the dialogue with accounting authorities in an effort to reduce, wherever possible, inappropriate disparities between regulatory and accounting standards”.

Source: Basel Committee on Banking Supervision, International Convergence of Capital Measurement and Capital Standards: A Revised Framework (Comprehensive Version: June 2006), Introduction, Paragraph 12.


Table of Content

1. Introduction 6

2. Accounting and Regulatory Context 8

2.1 IFRS Accounting Framework

2.1.1 Asset Valuation: Fair Value and Amortised Cost

2.1.2 Accounting Reforms Following the Financial Crisis

2.2 Basel Regulatory Framework

2.2.1 Regulatory Capital

2.2.2 Regulatory Assets

2.2.3 Basel-III Reforms

3. Survey of Largest European Banks I:

Accounting vs. Regulatory Capital and Assets

17

3.1 Balance Sheet and Regulatory Assets

3.2 Balance Sheet and Regulatory capital

3.3 Leverage Ratios and Tier-1 Capital Ratios

4. Survey of Largest European Banks II:

The Articulation of Accounting and Regulatory Measures

23

4.1 IFRS Equity to Tier-1 Reconciliation

4.2 Reconciliation of IFRS Assets to Risk-Weighted Assets

4.3 Pillar-3 Report

4.4 Leverage ratio

5. Case study: UBS 29

6. Conclusions and Points for Discussion 30

Bibliography 33

Appendices 35

1 UBS Reconciliation of IFRS and Basel II

2 Credit Suisse Chart on Relationship between Balance Sheet and Risk-Weighted Assets

3 Basel III Implementation Timetable


List of tables and figures

2. Accounting and regulatory context

Table 1 Comparing “qualitative” characteristics of BIS and IFRS reporting 8

Table 2 IASB project plan for replacement of IAS 39 10

Table 3 Minimum quantity and quality of capital under existing rules 12

Table 4 Banking book capital adequacy under Basel I 15

Table 5 Banking book capital adequacy under Basel II 16

Table 6 Basel III: calibration of the capital framework

Capital requirements and buffers (%)

16

3. Comparing accounting with regulatory capital and assets

Figure 1 Balance sheet and risk-weighted assets—end 2009 (€ billion) 18

Figure 2 Shareholders’ equity and tier-1 capital—end 2009 (€ billion) 20

Figure 3 Leverage ratios and tier-1 ratios—end 2009 (%) 22

4. The articulation of accounting and regulatory measures

Table 7 Survey of financial and regulatory reporting (2009) 24

Table 9 Credit Suisse: leverage ratio 26

Table 10 Financial characteristics of disclosers vs. non-disclosures 27

Appendix 1 35

Table 11 UBS: estimated reconciliation of IFRS assets to BIS risk-weighted assets

Table 12 UBS: reconciliation of IFRS equity to BIS tier-1 capital

Table 13 UBS: IFRS vs. regulatory assets, capital, and leverage

Appendix 2 40

Figure 4 Credit Suisse: risk-weighted assets

Appendix 3 41

Table 14 Basel III: Phase-in arrangements (shading indicates transition periods)


1. Introduction

This paper investigates the relationship between banks’ financial and regulatory reporting. We identify variations in principles-based reporting of capital and assets under international financial reporting standards (IFRS) and those prepared under prudential and conservative regulatory reporting practices under standards prepared under the Bank for International Settlements (BIS). The differences between BIS and IFRS capital and assets can lead to significant variations in what banks report as to capital adequacy and their balance-sheet leverage.

The relationship is important because of investors and other stakeholders’ reliance on Basel regulatory capital ratios alongside more traditional accounting measures. Indeed, long before the financial crisis, the Basel capital ratios had replaced more traditional accounting ratios as banks and investors’ chosen measures of capital strength. They usually feature in bank earning statements and annual reports among the key indicators of performance, alongside familiar accounting-based measures such as return on equity and the cost/income efficiency ratio.

In addition, the Basel-II framework, which banks were beginning to adopt just as the crisis hit, explicitly links regulatory compliance and market disclosure. Pillar 3 of Basel II is intended to “encourage market discipline by developing a set of disclosure requirements which will allow market participants to assess key pieces of information on the scope of application, capital, risk exposures, risk assessment processes, and hence the capital adequacy of the institution” (Basel Committee on Banking Supervision 2006). Banks are now obliged to publish pillar-3 reports.

Yet the crisis demonstrates that the interplay of financial and regulatory reporting contributed to misperceptions of banks’ financial health. There is now general agreement that banks were under-capitalised before the financial crisis—hence the Basel-III package of changes. But ahead of the crisis, banks appeared both well capitalised and profitable. They were reporting a combination of capital ratios well above the regulatory minimums—indeed, Basel II was predicated on no overall increase in capital in the banking system1—and high returns on equity. Taken together, the accounting and regulatory metrics were delivering what proved to be misleading messages about banks’ financial health.

The financial crisis has forced a fundamental reappraisal of both the accounting and regulatory frameworks governing banks. The International Accounting Standards Board (IASB) has a substantial programme of projects related to the financial crisis. These include the revisions to the fair-value measurement of financial instruments and a proposed new method for the reporting of loan loss impairments. Meanwhile, the Basel Committee on Banking Supervision (BCBS) has recently published its plans for Basel III, the centrepiece of which is much tougher capital and liquidity requirements for banks.

These reforms to the accounting and regulatory frameworks are being undertaken largely in parallel. This raises the question of how they relate to each other, and whether there is sufficient co-ordination between accounting and regulatory reporting. They also raise questions about the extent to which “fair values” and “true values” underlying financial reporting and prudential-based accounts can or should be reconcilable.2

Following the crisis, there has been recognition of the need to review the relationship between financial and regulatory reporting. The Basel Committee recently called for banks to provide a reconciliation of IFRS to Basel II-based capital (Basel Committee on Banking Supervision 2009). The UK’s Financial Services Authority (FSA) and Financial Reporting Council (FRC) published a discussion paper in June on enhancing the auditor’s contribution to prudential regulation (FSA and FRC 2010). This included a chapter on whether pillar-3 disclosures should be audited. The Committee of European Banking Supervisors (CEBS) has published assessments of the transparency of banks’ annual and pillar-3 reports (CEBS 2010a, 2010b).

1 Some banks, including Northern Rock, even expected a degree of capital relief from Basel II.

2 For example, see Laux and Leuz (2010), and Barth and Landsman (2010). Contrast with Bonio and Tsatsaronis

(2008)who argue for differences in prudential and shareholder reporting.


Though these steps are welcome, it is not yet clear whether regulators are giving the relationship between accounting and regulatory reporting sufficient priority. More far-reaching measures may be needed. This paper makes contributions, then, to a number of areas.

1. First, we identify conceptual differences in the qualitative characteristics of reports prepared under BIS and IFRS. These differences provide insight into the nature and implications of reports prepared for prudential purposes and reports prepared for stewardship purposes.

2. Second, we document the application of these standards to reveal the measurement and disclosure practices of a sample of large European banks that were significantly impacted by the crisis. We are the first to provide an analysis that takes into account the conservatism and prudential properties of capital ratios prepared under BIS and IFRS standards.

3. Third, we analyse the extent and nature of disclosure of both capital ratios and IFRS and BIS capital reconciliation by the banks to reveal the extent of variation in disclosure quality across the sample banks.

4. Finally, we investigate the nature and determinants of these differences in disclosure quality by reference to the capital, risk, financial, and productivity characteristics of the sample banks.

Our results support the prediction that banks face incentives to reveal the BIS versus IFRS differences is related to the desire by banks to reduce information asymmetry among market participants about the size and nature of their capital levels. We make a number of recommendations for enhancing the implementation of the reconciliation of capital, assets, and capital ratios prepared under the various regimes.

The empirical analysis is based on an analysis of the most recent financial statements of the twenty largest European banks. Despite the recent call of the Basel Committee, few of the banks provide an adequate reconciliation of financial and regulatory capital. Even more importantly, none of the annual reports contained an adequate reconciliation of financial and regulatory assets. This is despite the often huge differences in value between banks’ IFRS balance sheet assets and regulatory risk-weighted assets. Further, a majority of banks published their pillar-3 reports as separate documents, with little if any cross-referencing from the annual report.

The remainder of paper is organised as follows.

Section 2 provides an overview of the key accounting and regulatory reporting requirements, focusing on the changes to both IFRS and Basel following the financial crisis.

Section 3 sets out the measurement differences between assets and capital when valued for stewardship and for regulatory purposes. It provides an outline of the financial and operating characteristics of our sample of the twenty largest European banks. It also provides a comparison of the value of assets, capital, and capital ratios when measured or calculated according to accounting and regulatory principles.

Section 4 analyses the nature and determinants of banks’ disclosure practices. The analysis draws on the quality of disclosure concerning the nature and extent to which the sample banks reconcile accounting and regulatory measures of assets and capital as revealed in shareholder reports and Basel pillar-3 reports. This leads to analysis of the factors determining the quality of disclosure of both capital and leverage ratios.

Section 5 uses Swiss bank UBS as a case study for more detailed examination. UBS is chosen because the differences in value between its accounting and regulatory capital and assets are among the highest, though its disclosure is among the best of large European banks.

Section 6 concludes the paper with recommendations and points for discussion.

There are three appendices:

1. Provides additional data on UBS, including an attempted reconciliation of accounting and regulatory assets.


2. Reproduces from Credit Suisse’s 2009 annual report a chart mapping balance sheet and other exposures on to risk-weighted assets.

3. Summarises the Basel-III implementation plans.

2. Accounting and Regulatory Context

This section of the paper provides an overview of the main features of accounting and regulatory reporting relevant to the analysis. Clearly, this is a vast and complex area, with the relevant documentation running to hundreds of pages. Given the objectives of the paper, the overview concentrates on the composition and valuation of assets and capital under the IFRS accounting and Basel regulatory regimes.3

Table 1 summarises the major differences in terms of the qualitative characteristics of financial reporting between IFRS and BIS-based accounting principles.

In terms of the objectives of reporting, IFRS is intended primarily to provide shareholders and capital providers with information to enable them to make economic decisions. By contrast, BIS is primarily geared to prudential reporting requirements, i.e., assuring a regulator that there is sufficient regulatory or risk capital available to meet depositors’ requirements, under national-determined capital-adequacy principles.

The main elements of financial statements of IFRS include assets (determined mostly at market value), liabilities (partly determined using own credit risk where relevant), and residual equity.

By contrast, elements of regulatory financial statements under BIS are risk-weighted assets, credit risk, operational risk, market risk, and other relevant risks. Thus regulatory capital requirements of BIS may result in more conservatism in the balance sheet than permitted under IFRS.

The major measurement principles under IFRS are fair value, whereas under BIS “true values” are required to determine the risk components of capital. Finally, whereas pillar-3 reports must be produced in accordance with BIS principles, there are no requirements under IFRS for banks to produce risk capital, regulatory capital, or reconciliations with alternative regulatory accounting principles.

Table 1. Comparing “qualitative” characteristics of BIS and IFRS reporting

Qualitative characteristic BIS 2 IFRS

Objectives of reporting Prudence is a fundamental objective

Intended for shareholders value relevance; usefulness?

BIS is a prudential regulation regime, of which valuation of assets and liabilities and reporting of credit risk is one part

Only publicly quoted entities, therefore possible comparability problems. Assets or liabilities recorded only if relevant to going concern or credit risk

Elements of financial reports

Tier 1 is the main indicator of whether a bank’s capital is adequate

Market view is the main indicator of whether a bank’s capital is adequate

3 There are, of course, important differences between IFRS and US GAAP standards, with the IASB and US FASB

(Financial Accounting Standards Board) engaged in a major project to narrow differences and build a common set of accounting standards. This paper focuses on IFRS reporting because these are the standards under which UK and continental European banks report (as endorsed by the European Union). However, most of the IASB’s financial-crisis-related projects are being undertaken either with the FASB or as part of the Memorandum of Understanding that sets out the milestones that the FASB and the IASB have agreed to reach to demonstrate standard-setting convergence.


Capital (own funds) split by quality – tiers 1 to 3, basic and ancillary

No split of capital by quality

Intangible assets: via contractual rights and only if can be fair valued, else nil

IAS 38: via contractual rights

Measurement principles True value (risk-weighted value) Fair value

Disclosure principles Pillar-3 reports containing details of risks, risk-weightings, capital ratios

Balance sheet

2.1 IFRS Accounting Framework

2.1.1 Asset Valuation: Fair Value and Amortised Cost

Under IFRS, a so-called mixed attributes model is used to value assets (and liabilities), based on their initial recognition, on banks’ balance sheets.4 Financial assets and financial liabilities are measured on an ongoing basis either at amortised cost5 or at fair value:6

Loans and advances to, and deposits from banks and customers, and held-to-maturity (HTM) investments7 are generally accounted for at amortised cost using the effective interest method less any impairment losses (after initial recognition at fair value plus any directly attributable transaction costs).

In contrast, trading securities, financial instruments designated at fair value and available-for-sale investments (including all derivatives, whether held for trading or hedging) are measured at fair value.

Gains and losses on assets and liabilities recorded at fair value are accounted for differently from those recorded at amortised cost. Only realised gains are recognised on assets valued at amortised cost, while deposits are always valued at their face value.

Reductions in the value of assets recorded at amortised cost result in provisions through the income statement and corresponding write-downs on the balance sheet. In contrast, under fair value accounting, unrealised gains and losses are recognised. Under historical cost accounting, impaired assets are written down on the balance sheet to their recoverable value with impairment provisions made through the income statement. The impairment loss is the difference between the carrying value of the loan and the present value of the estimated future cash flows discounted at the loan’s original effective interest rate.

2.1.2 Accounting Reforms Following the Financial Crisis

4 This analysis applies only to what are generally identified as financial instruments. Any asset not identified as a

financial instrument would not be subject to the accounting and regulatory issues discussed in the paper (though most of the assets on bank balance sheets are financial rather than non-financial assets). 5 The amortised cost of a financial asset or financial liability is defined in IAS 39 as “the amount at which the financial

asset or financial liability is measured at initial recognition minus principal repayments, plus or minus the cumulative amortisation using the effective interest method of any difference between that initial amount and the maturity amount, and minus any reduction (directly or through the use of an allowance account) for impairment or uncollectibility” (IAS 39, definitions, paragraph 9). 6 Fair value is defined in IAS 39 as “the amount for which an asset could be exchanged, or a liability settled, between

knowledgeable, willing parties in an arm’s length transaction” (IAS 39, definitions, paragraph 9). 7 IAS 39, paragraphs 45, 46.


The IASB’s post-crisis reforms include both a simplification of the asset valuation framework and a possible new impairment method for assets valued at amortised cost. Table 2 summarises the major differences.

The IASB is replacing the notoriously complex IAS 39 with a new standard, IFRS 9.8 The IASB aims to replace all the requirements of IAS 39 by the second quarter of 2011. However, as set out in the table below, the Board has divided the development of the new standard, IFRS 9 Financial Instruments, into three main phases.9 Companies reporting under IFRS shall apply IFRS 9 for financial years beginning on or after 1 January 2013, though earlier application is permitted.10

Table 2. IASB project plan for replacement of IAS 39

Phases Status

1. Classification and measurement

IFRS 9 Financial Instruments for financial assets was published in November 2009. An exposure draft on the Fair Value Option for Financial Liabilities was published in May 2010 with a comment deadline of 16 July 2010.

2. Impairment methodology The exposure draft Amortised Cost and Impairment was published in November 2009 with a comment deadline of 30 June 2010.

3. Hedge accounting The IASB expects to publish an exposure draft in time to allow for finalisation by the second quarter of 2011.

Source: IASB.

Phases one and two cover the measurement of financial assets and the impairment of assets valued at amortised cost respectively.

Under phase one, the categories of financial assets in IAS 39, each with its own classification criteria, are replaced in IFRS 9 by a more principles-based approach. Chapters 4 and 5 of IFRS 9 require that all financial assets be:

Classified on the basis of the entity’s business model for managing the financial assets and the contractual cash flow characteristics of the financial asset.

Initially measured at fair value plus, in the case of a financial asset not at fair value through profit or loss, particular transaction costs.

Subsequently measured at amortised cost or fair value.

An important feature of IFRS 9 is that it sets specific criteria for assets to be measured at amortised cost. A financial asset shall be measured at amortised cost if both of the following conditions are met:11

8 The IASB and US Financial Accounting Standards Board (FASB) have since 2005 shared a long-term objective to

improve and simplify the reporting for financial instruments. They published a discussion paper, “Reducing Complexity in Reporting Financial Instruments”, in March 2008. In November 2008, almost concurrently with the introduction of the relaxed reclassification rules, the IASB added the project to its active agenda.

8 This was followed in April 2009 by

the announcement of an accelerated timetable for the replacement of IAS 39. 9 As the Board completes each phase, it is deleting the relevant portions of IAS 39 and creating chapters in IFRS 9 with

the new requirements. The first phase of the IAS 39 replacement project covers classification and measurement of financial assets. Following a July 2009 exposure draft, the Board issued in November 2009 Chapters 4 and 5 of IFRS 9 covering classification and measurement respectively. 10

Subject to EU endorsement in the case of companies listed in EU countries. 11

IFRS 9, paragraph 4.2.


The asset is held within a business model whose objective is to hold assets to collect contractual cash flows.

The contractual terms of the financial asset give rise on specified dates to cash flows that are solely payments of principal and interest on the principal amount outstanding.

Otherwise, a financial asset shall be measured at fair value, with reclassifications between amortised cost and fair value permitted only if there is a change in the reporting entity’s business model.

The new standard effectively establishes fair value as the default measurement category. Ironically from an historic perspective, the exception to fair value in IFRS 9 (a business model based on contractual cash flows of principal and interest) is the core business model of traditional retail banking.

Phase two covers amortised cost and the impairment of financial assets. The IASB (2009) published proposals for public comment in November 2009. Under the current incurred loss model, loans may be written down (impaired) only when evidence is available that a loan or portfolio of loans will not be repaid in full. Expected future credit losses may not be recognised until a trigger (loss) event has occurred.

The IASB is proposing to move from the current incurred loss impairment method to one based on expected losses. The proposed expected loss model requires that an entity:

Determine the expected credit losses on a financial asset when that asset is first obtained

Recognise contractual interest revenue, less the initial expected credit losses, over the life of the instrument

Build up a provision over the life of the instrument for the expected credit losses

Reassess the expected credit loss each period

Recognise immediately the effects of any changes in credit loss expectations.

The proposed IFRS would apply to all financial assets measured at amortised cost.

The proposed changes to the impairment method are important in the context of this analysis. Use of an expected loss approach incorporates a pro-active risk assessment into loan valuation. It moves the valuation of historic cost assets towards fair value. Indeed, what is the difference between a loan valued at historic cost minus its expected loss and a security “fair valued” by reference to a financial model?

Interestingly, impairment methodology is one area where regulators have argued for a change to the current accounting regime.12 The Basel Committee has developed a proposal to make operational the expected loss approach to provisioning proposed by the IASB. This is in many respects unsurprising. Basel II is based on a distinction between expected losses, for which provisions are made, and unexpected losses, which capital is intended to protect against. Loan impairment accounting based on expected rather than incurred losses would therefore bring greater consistency to the accounting and regulatory approaches.13

2.2 Basel Regulatory Framework

The basic components of the Basel regulatory framework are the definitions of capital and assets. The following tables, adapted from the March 2009 review of Lord Turner, Chairman of the Financial Services Authority, summarise each.

12

See Turner (2010). 13

As we discuss in section 5, below, the difference between expected and incurred loss bases leads banks to recognise as part of their BIS balance sheet “operational risk”, which is further broken down into expected and unexpected losses. There is no counterpart to this item on the IFRS balance sheet.


2.2.1 Regulatory Capital

Table 3 summarises the minimum quantity and quality of regulatory capital under existing rules. The most important characteristic relevant to this paper is its breakdown into the categories of core tier-1, non-core tier-1 and tier-2 capital.

Core tier-1 capital comprises shareholders’ equity and related minority interests. The book values of goodwill and intangible assets are deducted from core tier-1 capital, with other regulatory adjustments made for certain items in shareholders’ equity.

Qualifying hybrid capital instruments such as non-cumulative perpetual preference shares and innovative tier-1 securities are included in other, non-core tier-1 capital.

Table 3. Minimum quantity and quality under existing rules

Broad definitions of regulatory capital:

Core Tier 1: Common equity and retained earnings

Non-core Tier 1: Preferred stock and hybrid instruments

Tier 2: Subordinated debt

Allowable collective impairment allowances

Property revaluation reserves and unrealised gains on available-for-sale equities

Various regulatory adjustments and deductions, including:

Goodwill and intangible assets deducted from Tier-1 capital

Unconsolidated investments deducted from regulatory capital

Securitisation positions and excess of expected losses over impairment allowances deducted from regulatory capital

Total and Tier-1 requirements:

Total capital (Tier 1 + Tier 2) must be greater than 8% of Risk-Weighted Assets

Tier-1 capital must be at least 4% of Risk-Weighted Assets

Higher quality Tier-1 capital must be at least half of total capital

Core Tier-1 requirements:

Not formally defined within Basel 2 but BCBS guidelines suggest Core Tier 1 should be predominant part of Tier 1

Many jurisdictions, including UK, treated this as implying Core Tier 1 at least half of Tier 1

Effective minimum Core Tier 1 of 2% of Risk-Weighted Assets (except for market risk)


Trading book/market risk variant

Basel-II rules on quality of capital for market risk capital requirements are different from those for credit risk and more lenient.

As a result, a bank with significant trading book activity could face somewhat lower minimum Core Tier 1 than 2% and lower minimum Tier 1 than 4%

Notes:

1. In 2009, the UK FSA formalised a definition for Core Tier 1, which is now published consistently by the industry in the UK.

2. Total capital and Tier-1 requirements broadly unchanged between Basel I and Basel II.

3. An element of trading book/market risk capital can also be covered by “Tier-3” capital.

Sources: Basel Committee, The Turner Review, Financial Services Authority, March 2009 (adapted from Box 2A).

Tier-2 capital comprises:

Qualifying subordinated loan capital

Related minority interests

Allowable collective impairment allowances14

Unrealised gains on the fair valuation of equity instruments held as available-for-sale, and

Reserves from the revaluation of properties.

Regulators may limit the amount of hybrid capital instruments that can be included in tier-1 capital. Total tier-2 capital is limited to no more than tier-1 capital.

2.2.2 Regulatory Assets

Tables 4 and 5 summarise the treatment of banking book assets under Basel I and Basel II respectively.

Whether set by regulators (as under Basel I and under the Basel-II standardised approach), or determined by banks’ own analyses (as under the Basel-II internal ratings), the consistent characteristic most relevant to this paper is the risk-weighting of assets under the regulatory regime.

Under Basel I, assets were grouped into buckets that have different average risk characteristics and then assigned weights. These risk weights determined the capital requirements as a percentage of assets.

14

Under Basel II’s standardised approach to credit risk, general provisions can be included in tier-2 capital subject to the limit of 1.25% of risk-weighted assets. This follows the original 1988 accord, which allowed the inclusion of general provisions (or general loan-loss reserves) in tier-2 capital. Expected losses under the Internal Ratings-Based RB approaches are calculated by multiplying the counterparty will default (PD) by the quantified estimates of exposure at default (EAD) and loss given default (LGD). To the extent that they exceed accounting impairment allowances, expected losses are deducted from regulatory capital. Deduction must be on the basis of 50% from tier 1 and 50% from tier-2 capital. Where the total expected loss amount is less than total eligible provisions, banks may recognise the difference in tier-2 capital to a maximum of 0.6% of credit risk-weighted assets. At national discretion, a limit lower than 0.6% may be applied.


Table 4. Banking book capital adequacy under Basel I

Asset weight Required capital to weighted assets

Required capital to total assets

Corporate loans 100% * 8% = 8%

Residential mortgages 50% * 8% = 4%

Inter-bank 10% * 8% = 0.8%

Sources: Basel Committee, The Turner Review, Financial Services Authority, March 2009 (adapted from Box 2B), authors’ analysis.

Basel II is famously based around three pillars:

1. Pillar 1 covers the capital requirements for credit risk (including counterparty credit risk and securitisation requirements), market risk and operational risk. All these requirements are expressed in terms of risk-weighted assets.

2. Pillar 2 (supervisory review and evaluation process) involves banks and regulators assessing whether a bank should hold additional capital against risks not covered in pillar 1.

3. Pillar 3 is intended to encourage market discipline by requiring banks to publish specific, prescribed details of their risks, capital, and risk management under the Basel II framework.

Looking specifically at credit risk under Pillar 1, Basel II includes three approaches for the calculation of capital requirements.

The basic standardised approach requires banks to use external credit ratings to determine the risk weightings applied to rated counterparties, and to group other counterparties into broad categories to which standardised risk weightings are applied.

The internal ratings-based (IRB) foundation approach allows banks to calculate their credit risk capital requirements on the basis of their internal assessment of the probability that a counterparty will default (PD), but subjects their quantified estimates of exposure at default (EAD) and loss given default (LGD) to standard supervisory parameters.

The IRB advanced approach allows banks to use their own internal assessment both to determine PD and quantify EAD and LGD.


Table 5. Banking book capital adequacy under Basel II

Basel II: Standardised approach

Essentially, a more sophisticated version of Basel I, with a more sophisticated classification of loan types and the use of external ratings agency credit assessments in the assignment of risk weightings to certain categories of loans.

Basel II: Internal rating-based approach

Guiding principle:

Banks should do detailed analyses of the relative riskiness of different classes of assets at a granular level (e.g., multiple categories of corporate loans) and develop their own estimates of required economic capital, thus ensuring integration of capital adequacy conditions into bank risk management practices.

Estimates should be subject to parameters and limits defined by Basel-II regulation and subject to agreement by national supervisors.

Aggregate impact should leave total capital across the banking system broadly unchanged, while changing significantly the weights against different loans to reflect their inherent riskiness.

Key calculations:

Banks analyse historic patterns of loan losses on different types of loans (e.g., corporate loans as categorised by the banks on internal credit scoring/ranking system) and determine estimates of:

PROBABILITY OF DEFAULT * LOSS GIVEN DEFAULT = EXPECTED LOSS

This is translated into unexpected loss, the crucial driver of capital requirement, using defined methodologies.

Key parameters defined by regulation/supervisor guidance:

Floors on default possibilities

Maturity adjustment on corporate exposures to ensure higher capital requirement on long-term commitments.

Correlation parameters within asset classes.

Multipliers to derive possible unexpected loss from estimates of expected loss.

Calibration factor (currently 1.06) to ensure that overall banking system capital is broadly unchanged from Basel I.

Sources: Basel Committee, The Turner Review, Financial Services Authority, March 2009 (adapted from Box 2B), authors’ analysis.


2.2.3 Basel-III Reforms

Following the financial crisis, the Basel regulatory framework is to be substantially revised, as summarised in table 6. Under the agreements reached in September (Basel Committee on Banking Supervision 2010), the minimum requirement for common equity will be raised from the current 2%, before the application of regulatory adjustments, to 4.5% after the application of stricter adjustments. This will be phased in by 1 January 2015. The tier-1 capital requirement, which includes common equity and other qualifying financial instruments, will increase from 4% to 6% over the same period. The capital conservation buffer above the regulatory minimum requirement will be calibrated at 2.5% and be met with common equity, after the application of deductions.15 A countercyclical buffer within a range of 0% to 2.5% of common equity or other fully loss-absorbing capital will be implemented according to national circumstances. The countercyclical buffer, when in effect, would be introduced as an extension of the conservation buffer range.

Table 6. Basel III: Calibration of the capital framework, capital requirements and buffers (%)

Common equity (after deductions)

Tier-1 capital Total capital

Minimum 4.5 6.0 8.0

Conservation buffer 2.5 - -

Minimum plus conservation buffer

7.0 8.5 10.5

Countercyclical buffer range 0 – 2.5

Note: Countercyclical buffer based on common equity or other fully loss absorbing capital.

Sources: Basel Committee, September 2010.

A significant development in the new capital requirements is the inclusion of a non-risk-based leverage ratio16 designed to supplement the risk-adjusted capital ratios. In July, Governors and Heads of Supervision agreed to test a minimum tier-1 leverage ratio of 3% during the parallel run period (see the implementation timetable in the appendices). Based on the results of the parallel run period, any final adjustments would be carried out in the first half of 2017 with a view to migrating to a pillar-1 treatment on 1 January 2018 based on appropriate review and calibration.

The new standards are subject to transitional arrangements and phased implementation extending over several years. These are summarised in appendix 1.

15

The purpose of the conservation buffer is to ensure that banks maintain a buffer of capital that can be used to absorb losses during periods of financial and economic stress. While banks are allowed to draw on the buffer during such periods of stress, the closer their regulatory capital ratios approach the minimum requirement, the greater the constraints on earnings distributions. 16

In the United States, a minimum leverage ratio (based on a minimum ratio of tier-1 capital to total assets) is applied to large bank holding companies—see http://www.fdic.gov/regulations/laws/rules/6000-2200.html.

http://www.fdic.gov/regulations/laws/rules/6000-2200.html


3. Survey of the Largest European Banks I: Comparing Accounting with Regulatory Capital Assets

This section of the paper examines the differences in value between capital and assets as measured in accordance with accounting standards and as measured in accordance with regulatory principles.

To illustrate the differences, we have analysed data for the twenty largest European banks as measured by total balance sheet assets at the end of 2009.17

For this group of banks, we have compared:

The accounting and regulatory measures of assets

The corresponding measures of capital, and

The accounting and regulatory capital ratios that result from these measures.

For the analysis of assets, we have compared the value of total consolidated balance sheet assets with regulatory risk-weighted assets. The latter may include off-balance-sheet exposures, and under Basel II also include operational and market risk.

For the analysis of capital, we have compared balance sheet equity (including minority interests) with total tier 1 capital. Differences in value will reflect the regulatory adjustments made to accounting equity. For example, innovative tier-1 instruments will increase tier-1 capital relative to accounting equity while the deduction of goodwill and intangible assets for regulatory purposes will reduce tier-1 capital relative to accounting equity.

For our accounting-based capital leverage ratio, we have used the ratio of shareholders’ equity to total balance sheet assets. It appears that the leverage ratio proposed by the Basel Committee will be based on tier-1 capital—in other words, a combination of regulatory capital and accounting assets. The US leverage ratio for large bank holding companies is also based on a minimum ratio of tier-1 capital to total assets. However, we have used a pure accounting-based leverage ratio to draw out the contrast between accounting and regulatory capital and asset values.

3.1 Balance Sheet and Regulatory Assets

As figure 1 shows, for all banks the value of balance sheet assets is significantly higher than the value of their regulatory risk-weighted assets. This is so even though the latter may include off-balance-sheet exposures. total, for the twenty banks combined, the value of their balance sheet assets was almost three times higher than the value of their risk-weighted assets.

When individual banks are examined, the ratio of balance sheet to risk-weighted assets ranged from a low of just over 1.7 (Intesa Sanpaolo) to a high of nearly 6.5 (UBS).

17

All the banks have financial years ending on 31 December.


Figure 1. Balance sheet and risk-weighted assets—end 2009 (€ billion)

0 500 1 000 1 500 2 000 2 500

BBVA / Spain

Dexia / Belgium

Crédit Mutuel-CIC / France

Rabobank / Netherlands

Intesa Sanpaolo / Italy

Credit Suisse / Switzerland

Commerzbank / Germany

UBS / Switzerland

UniCredit / Italy

Société Générale / France

BPCE / France

Grupo Santander / Spain

Lloyds / UK

ING / Netherlands

Deutsche Bank / Germany

Barclays / UK

Crédit Agricole SA / France

HSBC / UK

RBS / UK

BNP Paribas / France

RWAs

Balance sheet assets

Notes:

1. Data for those banks that do not report in euros converted into euros at relevant 2009 year-end exchange rate (Source: ECB).

2. Risk-weighted assets are the total of credit risk, counterparty credit risk, operational risk and market risk assets as defined under Basel II, including assets that are off-balance sheet or do not correspond to balance sheet assets.

Sources: Banks’ reports and accounts.


3.2 Balance Sheet and Regulatory Capital

Figure 2 compares shareholders’ equity on the balance sheet and tier-1 capital defined in accordance with Basel regulatory principles.

Shareholders’ equity includes minority interests on the basis that, subject to various adjustments, they are also included in tier-1 capital.

Regulatory tier-1 capital is divided into core tier-1 and other tier-1 capital. Core tier-1 capital comprises shareholders’ equity and related minority interests. The book values of goodwill and intangible assets are deducted from core tier-1 capital, with various other regulatory adjustments made. Qualifying hybrid capital instruments such as non-cumulative perpetual preference shares and innovative tier-1 securities are included in other tier-1 capital.

The comparison in the chart is between shareholders’ equity and all capital, not just core tier-1 capital.

Overall, for the twenty banks combined, the value of shareholders’ equity was 1.24 times that of their tier-1 capital. The value of shareholders’ equity at the end of 2009 was higher than the value of regulatory tier-1 capital for seventeen of the twenty banks. When individual banks are examined, the ratio of shareholders’ equity on the balance sheet to tier-1 capital ranged from a low of just under 0.7 (Dexia) to a high of nearly 1.8 (Intesa Sanpaolo).


Figure 2. Shareholders’ equity and tier-1 capital—end 2009 (€ billion)

0 20 40 60 80 100 120

BBVA / Spain

Dexia / Belgium






UBS / Switzerland

UniCredit / Italy


BPCE / France


Lloyds / UK

ING / Netherlands


Barclays / UK


HSBC / UK

RBS / UK


Tier 1 capital

Shareholders' equity

Notes:

1. Data for those banks that do not report in euros converted into euros at relevant 2009 year-end exchange rate (Source: ECB).

2. Balance sheet equity figure is total equity at end 2009, including minority interests.

Sources: Banks’ reports and accounts.


3.3. Leverage Ratios and Tier-1 Capital Ratios

Figure 3 combines the data on assets and capital, as summarised in Figures 1 and 2, to compare banks’ leverage ratios with their tier-1 capital ratios.

The accounting-based leverage ratio is simply shareholders’ equity (including minority interests) as a proportion of total balance sheet assets. As noted earlier, it appears the leverage ratio proposed by the Basel Committee will follow the US leverage ratio in using regulatory tier-1 capital. However, we have chosen to use a pure accounting-based leverage ratio for this exercise. The purpose is to draw out the contrast between accounting and regulatory capital and asset values.

Though the value of most banks’ shareholders’ equity at the end of 2009 was greater than the value of their regulatory tier-1 capital, the differential between accounting and regulatory assets was in almost all cases significantly greater. As a result, the weighted tier-1 ratio for nineteen of the twenty banks was higher than the unweighted leverage ratio.

For fourteen of the twenty banks, the value of the tier-1 ratio at the end of 2009 was more than twice that of their leverage ratio.

When individual banks are examined, the values of their tier-1 ratio ranged from just under parity with the leverage ratio (Intesa Sanpaolo) to more than 5.8 times higher (Dexia).


Figure 3. Leverage ratios and tier-1 ratios—end 2009 (%)

0% 2% 4% 6% 8% 10% 12% 14% 16% 18%

BBVA / Spain

Dexia / Belgium






UBS / Switzerland

UniCredit / Italy


BPCE / France


Lloyds / UK

ING / Netherlands


Barclays / UK


HSBC / UK

RBS / UK


Tier 1 ratio

Leverage ratio

Notes:

1. Leverage ratio is the ratio of equity (including minority interests) to total balance sheet assets.

Sources: Banks’ reports and accounts, authors’ calculations.


4. Survey of Largest European Banks II: The Articulation of Accounting and Regulatory Measures

The previous section of the paper has set out the often very large differences in value, for the largest 20 European banks, between accounting and regulatory measures of capital and assets (particularly the latter), and the resulting differences between accounting and regulatory ratios of capital to assets.

One of the most important consequences of the Basel framework has been its de facto absorption into banks’ financial reporting. Details of regulatory capital do not form part of the audited financial statements.18 However, the Basel capital ratios occupy a central place in the commentary and analysis found in bank earnings statements and annual reports.19

Given investors’ and other stakeholders’ use of regulatory data, the scale of the apparent differences between the two underlines the importance of effective reconciliation. Yet investors’ reliance on regulatory capital ratios has developed without a framework for the articulation of the relationships between accounting and regulatory measures of capital and assets.

To illustrate the extent to which accounting to regulatory values are currently reconciled in banks’ financial reports, and the extent to which reporting practices are consistent or differ between banks, we have again analysed the quality of disclosures contained in the annual reports of the twenty largest European banks.

The survey covers:

IFRS equity to tier-1 reconciliation

Reconciliation of balance sheet to risk-weighted assets

Basel II pillar-3 reports:

o Whether included in the annual report or published as a separate document

o If the latter, whether cross-referenced from the annual report

The inclusion of an unweighted leverage ratio

The analysis of the quality of disclosure of the top 20 European banks are reported in table 7 and are based on a key word survey of the PDF versions of the banks’ 2009 annual reports and accounts (including both documents if they are published as separate documents). Although such a key word survey may miss certain disclosures, the exercise was not designed to be completely comprehensive. Rather, it was designed to find easily identifiable tables and commentary that articulate the relationship between financial and regulatory measures of assets and capital.

18

As noted in the FSA/FRC discussion paper 10/3, for firms reporting under IFRS, IAS 1 Presentation of Financial Statements requires information relevant to an understanding of the financial statements to be presented in the notes to the financial statements which are covered by audit. In particular, IAS 1 requires a firm to “disclose information that enables users of its financial statements to evaluate the entity’s objectives, policies and processes for managing capital”. This should include summary quantitative data about what it manages as capital and whether the firm has complied with externally imposed capital requirements during the period. 19

Most banks list the regulatory capital ratios alongside accounting-based measures such as return on equity and cost/income efficiency ratio in their coverage of financial highlights and key performance indicators. Further, more detailed discussions of capital in earnings statements and annual reports often focus on regulatory rather than accounting capital. In addition, some banks include profitability measures based on a combination of accounting and regulatory values (notably the return on risk-weighted assets) in their earnings statements and annual reports.


Table 7. Survey of financial and regulatory reporting (2009)

IFRS equity to tier-1 reconciliation

Reconciliation of balance sheet to risk-weighted assets

Pillar-3 report

If separate document, then cross-referenced in annual report

Leverage ratio

BBVA / Spain Not explicit (p228)

No Separate No No

Dexia / Belgium

No No Separate Basic (reference on p56 to availability on website)

No


No No Separate Basic (reference on p94 to availability on website)

No


Not explicit (p22)

No Separate No No


Not explicit (p373)

No (though table on p375)

Separate Basic (reference on p100, p271 to availability on website)

Yes (p24, 26)


Yes, though not explicit (p106)

No (though chart on relationship, p108)

Separate Basic (reference on p110 to availability on website)

Yes (p105)


Yes (p296) No Separate No Yes (p77)

UBS / Switzerland

Yes (p155) No Part of AR (p164)

N/A Yes (p156)

UniCredit / Italy

Not explicit (pp47-48, 410-415)

No (though table on p415)

Separate Basic (reference on p269 to availability on website)

Referred to (p20, 386)


Yes (p207) No Separate Basic (reference to forthcoming publication - p61)

No

BPCE / France Yes (p277) No Part of AR (p140)

N/A No


Not explicit (p97)

No Separate Basic (reference on p190 to publication)

No

Lloyds / UK Not explicit (p87)

No Separate No No

ING / Netherlands

Yes (p251) No Part of AR (p281)

N/A Yes (p3)


Yes (p296) No Separate No Yes (p2, 4, 103)


Barclays / UK No No Separate No Yes (p2)


Not explicit (p179)

No Part of AR (p177)

N/A No

HSBC / UK Yes (p289) No Separate Basic (reference to content and availability on p288)

No

RBS / UK Not explicit (p122, 331)

No Separate Basic (reference to content and availability on p125)

Yes (p18)


Yes (p140) No (though tables on p141-142)

Part of AR (p247)

N/A No

Notes: 1. Unlike the other banks, Credit Suisse reports under US GAAP rather than IFRS.

Sources: Bank annual reports and accounts and pillar-3 reports, authors’ analysis.

4.1 IFRS Equity to Tier-1 Reconciliation

All banks provide some form of analysis of regulatory capital in their annual reports. The analysis generally includes a table showing the composition and breakdown of regulatory capital between core tier-1, other tier-1 and tier-2 capital, often with further details on the constituents of each.

In some cases, it is possible to even reconcile tier-1 capital to shareholders’ equity based on the data in the breakdown of regulatory capital and the relevant entries in the balance sheet.

However, despite the call of the Basel Committee on this point, few banks in 2009 provided a highly visible and clear table whose primary purpose is to reconcile IFRS equity to tier-1 capital. In its June 2010 assessments of the transparency of banks’ annual and pillar-3 reports, the Committee of European Banking Supervisors (CEBS 2010a, 2010b) cites reconciliation of IFRS equity to tier-1 capital as an example of best practice reporting. It cites as examples UBS (see following section for a more detailed analysis) and Deutsche Bank (see table 8).


Table 8. Deutsche Bank: reconciliation of IFRS shareholders’ equity to Basel tier-1 capital

€ million 31 Dec. 2009 31 Dec. 2008

Total shareholders’ equity 36,647 30,703

Unrealised net gains (losses) on financial assets available for sale

121 882

Unrealised net gains (losses) on cash flow hedges 136 349

Accrued future dividend (466) (310)

Active book equity 36,438 31,624

Goodwill and intangible assets (10,169) (9,877)

Minority interest 1,322 1,211

Other (consolidation and regulatory adjustments) 397 63

Noncumulative trust preferred securities 10,616 9,622

Items to be partly deducted from tier-1 capital (4,198) (1,549)

Tier-1 capital 34,406 31,094

Source: Deutsche Bank Annual Report 2009, p. 296 .

4.2 Reconciliation of IFRS Assets to Risk-Weighted Assets

Although many banks provided a full or comprehensive reconciliation of IFRS balance sheet capital to BIS capital, none provided a corresponding reconciliation of IFRS assets to Basel risk-weighted assets.

Credit Suisse included in its 2009 annual report a chart (reproduced in appendix 2) illustrating the main types of balance sheet positions and off-balance-sheet exposures that translate into market, credit, operational, and non-counterparty risk-weighted assets. The chart does not provide a summary reconciliation. It does not include values for the main balance sheet asset items, only values for the main categories of risk-weighted assets. However, it does provide an overview of the structural relationship between accounting and regulatory assets.

4.3 Pillar-3 Report

The interaction with accounting disclosures is covered in paragraphs 813-816 of Basel II. Basel II gives bank management discretion in determining the appropriate medium for and location of the pillar-3 disclosure (paragraph 814).

Of the twenty banks surveyed, five included the pillar-3 disclosure as part of their annual report. Most issued the pillar-3 report as a separate document, often with poor if not non-existent cross-referencing from the annual report.

4.4 Leverage Ratio

Ahead of its introduction as part of Basel III, some banks are already including a leverage ratio in their annual reports.

The two Swiss banks included in the survey must already comply with a new leverage ratio20 introduced by Swiss Financial Market Supervisory Authority FINMA.21 The Swiss leverage ratio is set for both banks at a

20

SFBC and large banks agree to set higher capital adequacy targets and introduce a leverage ratio, available from: http://www.finma.ch/archiv/ebk/e/publik/medienmit/20081204/mm-em-leverageratio-20081204-e.pdf

http://www.finma.ch/archiv/ebk/e/publik/medienmit/20081204/mm-em-leverageratio-20081204-e.pdf


minimum of 3% at group level. The FINMA leverage ratio is being progressively implemented until it is fully applicable on 1 January 2013. The ratio is based on tier-1 capital and total assets on a non-risk-weighted basis, though with various adjustments to the latter.

Table 9 shows the reported leverage ratio for Credit Suisse in 2009.

Table 9. Credit Suisse: leverage ratio

CHF billion Group Bank

End of 2009 2008 2009 2008

Adjusted assets (1)

Average assets 1,047 1,312 1,026 1,291

Adjustments:

Assets from Swiss lending activities (2) -137 -138 -114 -115

Cash and balances with central banks -32 -38 -32 -38

Other -19 -18 -15 -16

Adjusted average assets 859 1,118 865 1,122

Tier-1 capital 36.2 34.2 34.7 34.2

Leverage ratio (%) 4.2 3.1 4.0 3.0

Notes: 1. Adjusted assets are calculated as the average of the month-end values for the previous three

calendar months. 2. Excludes Swiss interbank lending. 3. Credit Suisse reports under US GAAP rather than IFRS.

Source: Credit Suisse Annual Report 2009, p. 105 .

4.5 Determinants of Disclosure Quality

To examine the nature and determinants of variations in the quality disclosures reported in table 7, we undertook an analysis of the determinants of the disclosures across the sample. We first identified basic financial characteristics related to performance and position and size of the banks from Bankscope. We then estimated the beta risk for the firm samples using CRSP. Finally, we identified the value added and productivity of the banks (P1, value added per employee; P2, value added divided by costs) per the UK department of innovation learning and skills value added scoreboard of the top 600 European companies.

Various explanations may exist for why banks face incentives to voluntarily disclose IFRS and BIS capital and capital ratios. One explanation is that banks rely on debt markets, and therefore might decide to reveal this information to enhance their visibility (Ball and Sadka 2008). An alternative explanation is that banks have incentives to reveal these financial calculations to reduce information asymmetry among equity market participants (Armstrong et al. 2010). Discriminating among these alternative explanations is important to this study because evidence of any cross-sectional variation in disclosure practice with risk and financial characteristics suggests the latter, whereas a relation to size or reported Basel-based capital ratios supports the former.

These characteristics were collected for the twenty sample banks for the period from 2006 to 2009, the latest reporting dates available after the 2005 implementation of IFRS. We then examined the strength of

21

The Swiss Federal Banking Commission (SFBC), along with the Federal Office of Private Insurance (FOPI) and the Anti-Money Laundering Control Authority, has been merged into the Swiss Financial Market Supervisory Authority FINMA.


relation between these characteristics, and incentives facing the sample banks to (a) reconcile BIS to IFRS capital and (b) the capital or leverage ratio. Table 10 reports the results in panels a and b.22

Table 10. Financial characteristics of disclosers vs. non-disclosers

Disclosers (n=10) Non-disclosers (n=10) T statistic

Average Std. dev. Average Std. dev.

a. IFRS vs. BIS capital

Equity 38,382 32,658 9,113 14,006 -0.833

Off-balance-sheet assets

146,295 193,776 20,881 37,720 2.265***

Subordinated debt

11,665 12,222 3,852 6,872 1.794*

Net interest margin

0.90 5.66 1.75 3.26 3.091***

Return on asset

0.31 5.84 1.81 5.87 0.755

Return on equity

6.27 13.18 5.84 12.74 2.105***

Total capital ratio

8.85 7.44 3.51 5.33 -0.880

Tier-1 capital ratio

7.37 6.77 2.65 4.05 0.374

Beta 0.73 5.66 1.17 0.79 -1.073

Market value equity

72,503 164,183 156,826 230,930 -1.073

Value added 11,770 7,112 7,275 6,547 3.415***

P1 (VA per employee)

119.02 57.84 127.05 74.47 4.268***

P2 (VA/costs) 180.9 57.21 192.19 73.56 1.143

b. Capital ratio

Equity 28679 34809 17816 18883 1.971**

Off-balance-sheet assets

100,862 184,157 66,314 100,862 -1.543

Subordinated debt

9,566 12,666 5,950 7,581 2.340***

Net interest margin

1.34 5.83 1.31 2.63 -1.506

22

These results were verified using non-parametric tests (Chi-squared, Wilcoxon match paired) as well as via logistic regressions and OLS. The results of the robustness and more sophisticated tests are not shown.


Return on asset

1.71 8.04 0.42 2.43 4.009***

Return on equity

5.26 16.13 6.87 8.78 0.304

Total capital ratio

8.84 7.48 3.53 5.34 0.621

Tier-1 capital ratio

6.97 6.76 3.05 4.48 0.785

Beta 1.26 5.58 0.64 0.77 -0.078

Market value equity

216,018 256,597 23,310 19,408 3.195***

Value added 12481 7798 7564 5091 1.544

P1 (VA per employee)

144.43 78.42 101.64 43.59 -0.062

P2 (VA/costs) 182.50 58.50 190.65 72.75 2.091***

Note: * 10% level of significance; ** 5% level of significance; ***1% level of significance.

In general, disclosing EU banks (about half the sample) tend to have higher equity, off-balance-sheet, subordinated debt, net interest margin, ROA, ROE, and capital ratios and beta and market value of equity and value added and productivity ratios than do non-disclosing banks.

Panel a of table 10 reports the variations in bank financial and other characteristics of discloser versus non-discloser sub-samples. Supporting an information asymmetry explanation, we find that the propensity to disclose IFRS versus BIS capital reconciliations is statistically and positively significantly related to equity capital levels, and extent of subordinated debt, net interest margins, return on equity, value added, and productivity (defined as value added per employee).

Panel b of table 10 reports key components of capital ratios. We find that the propensity to disclose the capital ratios is related to equity, subordinated debt, return on assets, market value of equity, and productivity (defined as value added divided by costs).

These results again support the notionthat an information asymmetry perspective explains the propensity to disclose information pertaining to a reconciliation of BIS to IFRS capital and capital ratios. There is only limited evidence in support of a political visibility or debt-market hypothesis, as there appears to be little systematic relationship between the propensity to disclose reconciliations and/or capital ratios and the size and/or capital ratio of the firm.

However, we warn that the above results are tentative and that additional analysis and corroboration are necessary before more definite inferences can be drawn. In particular, further evidence is needed to study the incentives facing firms to implement best practice on the extent of disclosures of assets, capital, and capital ratios. We discuss these issues in the next section with a case study of a major Swiss bank, UBS.

5. UBS Case Study

UBS is one of the few top-twenty European banks identified in table 7 as providing detailed asset, capital, and capital ratio information concerning the IFRS and BIS bases in its annual report. To implement best practice reporting, we therefore analysed the 2009 annual accounts of UBS to ascertain the extent to which a full reconciliation is possible for each of these items, in accordance with BIS (2010) recommendations.


Our analysis is reported in appendix 1. It provides a comparative analysis of BIS assets, capital, and capital ratios for both 2009 and 2008 reporting years.

We first analysed the extent of asset-based reconciliations. This involved a reconciliation of the published balance sheet assets as reported under IFRS for the year ended 31 December 2009, together with the schedule of risk-weighted assets used for estimating Basel-II ratios.

We identified eight items that were on the IFRS balance sheet, but not on the BIS risk-weighted assets included in the annual report. We identified a further eight items that appeared on both reports. Finally, we identified eight items included only in the BIS risk-weighted assets. The most significant items on the IFRS balance sheet but not reported under BIS risk-weighted assets included assets at replacement, cash collateral on securities, and trading securities. The most significant items on the BIS risk-weighted assets which did not have any counterpart on the IFRS balance sheets were the estimates of operational risk and market risk relevant to estimating regulatory capital. UBS provided no explanations for these apparent differences.

As expected, the risk-weighting of items resulted in an estimate of risk-weighted assets at least six times more conservative than that of their unweighted IFRS counterparts. These variations persisted from 2008 to 2009.

We then analysed the capital reconciliation. Unlike the asset-based reconciliation, which had to be deduced from various disclosures in the annual report, the IFRS and BIS capital reconciliation was shown explicitly in a single table. This has relatively immaterial differences, except for the deduction of intangible assets from capital to compute tier-1 BIS capital, which has no counterpart in IFRS.

We finally reconciled the asset to capital ratio and we find that the variations are fully explained by the above separate reconciliations of assets and capital. However, there is no single source of information provided in the UBS annual report.

Our analysis implies that best-practice reporting of asset, capital, and capital ratios by UBS in its 2009 annual report still leaves room for confusion as to the inter-connections and articulation of BIS-prudential and IFRS stewardship-oriented reporting. We have therefore set out in appendix 2 what we regard as a more comprehensive reconciliation of all three components of the calculation.

Based on our inferences of the determinants of disclosure quality in section 5 above, we argue that mandating these reconciliations for all banks would significantly reduce the cost of capital for these banks.

6. Conclusions and Points for Discussion

The paper concludes with a call for much better disclosure and improved transparency of the key links between accounting and regulatory measures of assets and capital.

We argue that the lack of a structured presentation of the relationship between the accounting and regulatory measures contributed to the perception, ahead of the financial crisis, that banks were sufficiently, if not strongly capitalised.

In their reporting, banks tended to focus on their “strong” Basel capital ratios rather than the value of their risk-weighted assets on which those ratios depend. Yet the capital ratios looked strong only because the value of regulatory assets was so much lower than the value of unweighted balance sheet assets. Banks highlighted their apparently strong capital ratios without explaining clearly how those capital ratios related to relevant accounting numbers. As a result, investors failed to realise that “strong” Basel tier-1 ratios were compatible with surprisingly high unweighted leverage.

We also find that the top-twenty European banks have incentives to disclose the key components in calculating IFRS-based capital ratios and the equivalent BIS-based capital ratios in order to reduce information asymmetry among investors.


Finally, even an analysis of best-practice reconciliation of assets, capital, and capital ratios by UBS in its 2009 annual report shows that major improvements are still required.

In relying on Basel capital ratios as their main indicators of capital strength, investors and other stakeholders are implicitly relying on a parallel but unpublished balance sheet made up of regulatory capital and assets fashioned from accounting data drawn up in accordance with Basel regulatory principles. There needs to be much greater clarity on the interaction of this shadow regulatory balance sheet and financial reporting.

The Basel Committee’s plans for a non-risk-based leverage ratio that will “serve as a backstop to the risk-based measures” (Basel Committee on Banking Supervision 2010) add to the case for greater clarity.23 Despite their simplicity, the risk is that leverage ratios will add to the difficulties of deciphering banks’ underlying capital strength. There are likely to be large differences in value between leverage ratios and risk-adjusted capital ratios. The Basel Committee’s reforms propose a tier-1 leverage ratio of 3% compared with a minimum tier-1 capital requirement of 6%.24 Leverage ratios will serve as an effective “backstop” to risk-based measures only if investors and other stakeholders understand the relationship between the two measures.

In conclusion, we propose four main reforms:

Implementation by all banks of a reconciliation of IFRS equity to regulatory tier 1 capital

First, despite the Basel Committee’s call for a full reconciliation of regulatory capital elements back to the balance sheet in the audited financial statements, our review of bank practice in 2009 (section 4) found that many banks did not provide such reconciliation. All banks should do so.

Implementation of an accompanying reconciliation of IFRS assets to regulatory risk-weighted assets

Second, the reconciliation of accounting and regulatory capital should be accompanied by a reconciliation of accounting and regulatory assets. There needs to be transparency about both numerator and denominator.

Currently, as shown with the example of UBS in appendix 2, it is extremely difficult to relate data on balance sheet assets to data on risk-weighted assets even in the case of banks whose reporting exemplifies current best practice.

We acknowledge that reconciliation of accounting and regulatory assets is less straightforward than reconciliation of accounting and regulatory capital because of the breakdown of risk-weighted assets under Basel into credit risk, counterparty credit risk, market risk, and operational risk.

Market and operational risk assets do not correspond to balance sheet assets. Even some credit risk assets may be off-balance sheet.

The reconciliation should therefore:

Set out which regulatory risk-weighted assets do and which do not correspond to IFRS balance sheet assets, and

For those regulatory assets that do correspond to balance sheet assets, set out which balance sheet headings the regulatory assets correspond to.

This would improve investors and other stakeholders’ understanding of the relationship between accounting and regulatory assets, with clarity on the regulatory weighting applied to accounting assets.

23

As documented in the paper, in anticipation of the Basel changes, some European banks and regulators have already introduced measures of leverage among their key performance indicators. 24

During the parallel run period for the leverage ratio and excluding the proposed capital conservation buffer for the risk-weighted tier-1 ratio.


Greater prominence of accounting to regulatory reconciliations

The call is not for further weighty disclosure. Bank financial reporting already suffers from an endemic “woods for the trees” problem.25 Even in the case of banks that currently provide a clear reconciliation of IFRS equity to regulatory tier-1 capital, the reconciliation is often found deep in the annual report.

The challenge, to belabour the cliché, is not to add more trees but to improve the map of the woods. The reconciliations of accounting to regulatory capital and assets should be prominently summarised and discussed in the annual report’s business or financial review, with clear signposting of the full schedules.

Improved signposting of Pillar-3 reports

We recommend that banks publish their pillar-three reports as part of, or as an appendix to them, rather than as separate documents. There also needs to be clear signposting from the relevant content of the annual report and accounts to the pillar-3 report.

Our research findings are limited in scope and can be extended in a number of directions. For example, research can be done to examine the incremental information content of the itmes that differ between Basel- and GAAP-based disclosures to market participants. Further research is also needed to examine the relation of the identified differences and various risk and other financial characteristics of banks, and to examine cross-sectional variations across a broader sample of banks from a wider range of countries and which may or may not enjoy implicit guarantees of state support. Further research is also needed to identify the relevance and impact of the differences on credit rating decisions. The interaction of Basel, GAAP, and other government depository insurance schemes and the broader accountability of governments that provide this insurance is also a fruitful area for further research. Finally, further research is needed to identify the broader impact of the identified differences between regulatory- and GAAP-based numbers in the broader financial sector, particularly non-bank depositary institutions, credit unions and societies, insurance companies, and investment organisations and pension funds that are subject to a similar regulatory regime (e.g., Solvency II). We hope this paper stimulates further research into these and other potential areas of interest to policymakers, educators, and the industry and investment communities.

25

For example, HSBC’s 2009 annual report runs to 500 pages, with its pillar-3 report a further fifty-eight pages.


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Appendix 1:

The appendix illustrates how an IFRS to BIS capital requirement schedule could be constructed, drawing on the disclosures provided by UBS for 2008–2009. These disclosures are found in the “Risk and treasury management” section of its annual report. The disclosures provide sufficient information to enable an analyst to construct the schedule of variations between IFRS versus BIS-based capital, as well as risk-weighted and unweighted assets. The latter are not specifically reconciled by UBS but can be deduced from the detailed disclosures on risk-weighted assets.

The appendix table also shows that a number of items are not shown on the balance sheet reported by UBS, and vice-versa. For example, while the relevant items in the balance sheet pertaining to credit risk are comparable one-for-one with those in the risk-weighted asset schedule, there are variations in the magnitude of these items. Furthermore, the risk weighting of individual items further reduces the value of the risk-weighted items. The table shows that the only comparable BIS and IFRS assets are those related to credit-risk. Other elements of risk, including operational risk, market risk, and collateral risk, have no counterparts in the balance sheet. On the other hand, other items in the balance sheet, such as deferred tax assets, replacement cost items, and so on have no counterparts in the BIS risk-weighted assets calculations.

The risk weightings vary from item to item and year to year. The average of the magnitude of the item multiplied by the risk weighting specified for that item does not correspond to the reported risk-weighted asset item which is used as a basis for the capital ratio. This may be the result of using a ceiling, rather than a mid-point, as the basis for the BIS capital ratio calculation. By contrast, the major differences between IFRS and BIS capital are provided in a reconciliation schedule by UBS, and are in any case less significant than the (unreconciled) asset differences.

The overall differences identify a significantly lower value of risk-weighted BIS-basedassetsthan IFRS asset values, whereas the IFRS-based and BIS-based capital values are not materially differen


Table 11. UBS: estimated reconciliation of IFRS assets to BIS risk-weighted assets

2009 2008

Assets (UBS, pp. 165, 166) Avg. Risk weighting

IFRS assets Regulatory net exposure

RWA average

RWA ceiling

Difference IFRS-BIS

Avg. Risk weighting

IFRS assets Regulatory net exposure

RWA average

RWA ceiling

Difference IFRS-BIS

Comprising:

Cash and balances 4% 20,899 18,016 721 663 20,236 6% 32,744 22,802 1,368 1,349 31,395

Due from banks 20% 46,574 17,893 3,579 3,490 43,084 25% 64,451 28,759 7,190 7,066 57,385

Loans 19% 306,828 248,948 47,300 48,363 258,465 24% 340,308 274,278 65,827 66,547 273,761

Financial assets FV 33% 10,223 4,557 1,504 1,481 8,742 20% 12,882 5,649 1,130 1,123 11,759

Off balance sheet 27% - 42,064 11,357 11,417 - 11,417 34% - 45,008 15,303 15,105 - 15,105

Stbanking 331,478 - 376,496 -

Derivatives 39% 96,063 37,465 37,454 - 37,454 42% 190,047 79,820 79,663 - 79,663

Securities financing 10% 40,756 4,076 4,147 - 4,147 16% 63,825 10,212 10,404 - 10,404

ST Traded 136,819 - 253,872 -

Trading PF asset 28% 188,037 25,803 7,225 7,257 180,780 40% 271,838 32,848 13,139 13,255 258,583

Financial invest AFS 2% 81,757 79,680 1,594 1,957 79,800 15% 5,248 3,027 454 467 4,781

Accrued income 88% 5,816 5,299 4,663 4,663 1,153 93% 6,141 5,036 4,683 4,665 1,476

Other 98% 7,336 6,472 6,343 6,326 1,010 82% 18,811 10,668 8,748 8,814 9,997

ST Other products 117,254 51,579

Other IFRS Assets not risk weighted

Cash collateral on securities borrowed

63,507 63,507 122,897 122,897

Reverse purchase agreements 116,689 116,689 224,648 224,648


Trading PF assets pledged as collateral

44,221 44,221 40,216 40,216

Positive replacement values 421,694 421,694 854,100 854,100

Investment in associates 870 870 892 892

Property and equipment 6,212 6,212 6,706 6,706

Goodwill and intangible assets 11,008 11,008 12,935 12,935

Deferred tax assets 8,868 8,868 - -

TL Credit risk: 1,340,539 585,551 125,825 127,218 2,014,817 681,947 207,873 208,458

Securitisation exposure 33% 8,515 - 8,515 33% 8,515 - 8,515

Settlement risk 103 - 103 103 - 103

Equity exposure outside trading book

4,657 - 4,657 5,487 - 5,487

Total credit risk 140,493 - 140,493 222,563 - 222,563

Non-counterparty related risk 7,026 - 7,026 7,411 - 7,411

Market risk 12,861 - 12,861 27,614 - 27,614

Operational risk 46,144 - 46,144 44,685 - 44,685

TOTAL Risk-Weighted Assets 1,340,539 206,524 1,134,015 2,014,817 302,273 1,712,544

Sources: UBS financial reports, authors’ estimates.


Table 12. UBS: reconciliation of IFRS equity to BIS tier-1 capital

2009 2008

IFRS Reconciliation BIS IFRS Reconciliation BIS

Share capital 356 0 356 293 0 293

Share premium 34,786 3,888 34,786 25,250 8,500 33,750

Net income recognised directly in equity, net of tax

-4,875 -1,214 -6,089 -4,335 -1,265 -5,600

Revaluation reserve from step acquisitions, net of tax

38 0 38 38 0 38

Retained earnings 11,751 -4,687 7,064 14,487 -7,716 6,771

Equity classified as obligation to purchase own shares

-2 2 0 -46 46 0

Equity attributable to minority interests

7,620 -295 7,325 8,002 -495 7,507

Treasury shares / deduction from own shares (1)

-1,040 -1,384 -2,424 -3,156 1,668 -1,488

Mandatory convertible notes to the Swiss Confederation

- - - 0 6,000 6,000

Total balance sheet equity 48,633 -3,690 44,944 40,533 6,738 47,271

Less goodwill, intangible assets, and other deductions (2)

-13,146 -14,117

Less accrual for expected future dividend payments

0 0

Eligible BIS tier 1 capital 31,798 33,154

Notes: 1. Generally, treasury shares are fully deducted from equity under IFRS, whereas for capital adequacy purposes this position covers the following: (i) net long

position in own shares held for trading purposes; (ii) own shares bought for unvested or upcoming share awards; and (iii) accrual build for upcoming share awards.


2. “Other deduction items” include primarily 50% of the deductions for net long position of non-consolidated participations in the finance sector, expected loss on advanced internal rating-based approach portfolio less general provisions (if difference is positive); expected loss for equities (simple risk weight method); first loss positions from securitization exposures.

Sources: UBS financial reports.

Table 13. UBS: IFRS vs. regulatory assets, capital, and leverage

2009 2008

IFRS BIS Multiple IFRS BIS Multiple

Assets (CHF million) 1,340,538 206,525 6.49x 2,014,815 302,273 6.67x

Equity / tier 1 capital (CHF million) 48,633 31,798 1.53x 40,533 33,154 1.22x

Leverage / tier 1 ratio (%) 3.6 15.4 0.23x 2.0 11.0 0.18x

Note: Leverage ratio based on equity as a proportion of total balance sheet assets. This differs from the FINMA leverage ratio calculation included in UBS’s annual report (p156 in 2009 report).

Sources: UBS financial reports, authors’ calculations.


Appendix 2: Credit Suisse chart on relationship between balance sheet and risk-weighted assets

Figure 4. Credit Suisse: risk-weighted assets

Off-balance sheetderivatives

Off-balance sheetexposures

Balance sheetpositions

Risk-weighted assets222

Guarantees,commitments

Market risk 18

Credit risk 165

Trading assets &investments (1)

Trading liabilities,short positions

Securities financingtransactions (2)

Securities financingtransactions (2)

Loans, receivablesand other assets

Premises andequipment

Operational risk 32

Non-counterparty risk 7

Processes,people,systems,externalevents

32

59

18

4

102

7

Notes:

1. Includes primarily trading assets, investment securities and other investments.

2. Includes central bank funds sold, securities purchased under resale agreements and central bank funds purchased, securities sold under repurchase agreements and securities lending transactions.

3. Credit Suisse reports under US GAAP rather than IFRS.

Source: Credit Suisse Annual Report 2009, p. 108.


Appendix 3: Basel-III implementation timetable

Table 14. Basel III: Phase-in arrangements (shading indicates transition periods)

2011 2012 2013 2014 2015 2016 2017 2018 As of 1 January 2019

Leverage Ratio Supervisory monitoring

Parallel run 1 Jan 2013 – 1 Jan 2017 Disclosure starts 1 Jan 2015

Migration to Pillar 1

Minimum Common Equity Capital Ratio 3.5% 4.0% 4.5% 4.5% 4.5% 4.5% 4.5%

Capital Conservation Buffer 0.625% 1.25% 1.875% 2.50%

Minimum common equity plus capital conservation buffer

3.5% 4.0% 4.5% 5.125% 5.75% 6.375% 7.0%

Phase-in of deductions from CET1 (including amounts exceeding the limit for DTAs, MSRs and financials)

20% 40% 60% 80% 100% 100%

Minimum Tier-1 Capital 4.5% 5.5% 6.0% 6.0% 6.0% 6.0% 6.0%

Minimum Total Capital 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% 8.0%

Minimum Total Capital plus conservation buffer

8.0% 8.0% 8.0% 8.625% 9.125% 9.875% 10.5%

Capital instruments that no longer qualify as non-core Tier-1 capital or Tier-2 capital

Phased out over 10-year horizon beginning 2013

Liquidity coverage ratio Observation period begins

Introduce minimum standard

Net stable funding ratio Observation period begins

Introduce minimum standard

Note: (all dates are as of 1 January)

Source: Basel Committee.




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