Regulatory and financial reporting essential for effective banking supervision and financial stability
Dinner speech by Danièle Nouy, Chair of the Supervisory Board of the ECB,
Fourth ECB conference on accounting, financial reporting and corporate governance for central banks,
Frankfurt am Main, 3 June 2014
Good evening, ladies and gentlemen.
It gives me great pleasure to welcome you to tonight’s dinner, which concludes the first day of this year’s ECB accounting conference. I know you have already had an intensive day of presentations and discussions on various accounting matters, so I will try to keep my intervention brief.
However, given the importance of the subject matter, not least within the context of the new supervisory tasks assigned to the ECB, I hope you will allow me to share a few thoughts on ways of improving the effectiveness of both financial and regulatory reporting.
I would like to start by explaining what financial and regulatory reporting are, why they matter and who the main addressees are. I will then turn to the lessons learned from the recent financial crisis, and the improvements already made to reporting frameworks in the EU. Lastly, I will look at the way forward, including the challenges of establishing and operating banking supervision within the Single Supervisory Mechanism (SSM).
What I would like you to take away from my remarks this evening are three things:
First, that “reporting” is a tool that provides useful information to relevant stakeholders, and that effective communication between companies, in particular credit institutions, and their stakeholders is important. Therefore, the information provided by companies must be relevant and understandable.
Second, that the information provided should be comparable across jurisdictions.
And third, that the special role of credit institutions for the public at large needs to be explicitly acknowledged. Reporting requirements should therefore be designed in such a way that they do not endanger financial stability.
What are financial reporting and regulatory reporting and why do they matter?
Both academics and market participants often refer to “reporting” as a “language” or a “communication tool” between a particular company and its external stakeholders. In their view, the aim of such communication is to reduce the information gap between these external stakeholders and the company’s management, commonly referred to as “information asymmetry”. Yet, this communication can only be effective if both the management and the external stakeholders speak the same language. In other words, the information provided must serve the needs of the stakeholders involved – and, ideally, be presented in a “catchy” way. International accounting standard-setters have developed their own interpretations of these requirements: in their jargon, financial reporting information must be “decision-useful” and “understandable”. In my view, this could easily be summarised by the term “transparency”. Financial reporting information can be said to be “transparent” if it provides correct insights into the financial position and performance of a company, and if it reveals any risks the company is facing.
However, this is not enough. Effective communication is facilitated significantly by the global spread of a particular language. In reporting terms, there is no doubt that this can best be achieved by a single set of global reporting standards. Applying the same language globally reduces the risk of misunderstandings and enhances consistency of the information provided. This could be summarised by the term “comparability”. The significance of this criterion is also acknowledged by accounting standard-setting bodies, such as the International Accounting Standards Board (IASB).
Having said that, reporting can have different shapes, functions and addressees. This is why it is important to differentiate between financial reporting and regulatory reporting.
Financial reporting information, on the one hand, is derived from accounting data and published via audited financial statements. It primarily targets market participants, in particular equity investors and other providers of risk capital. In the EU, listed companies are required to prepare their financial statements in accordance with International Financial Reporting Standards (IFRSs), as adopted by the European Commission.
By contrast, regulatory reporting comprises, among other things, the IFRS-based financial reporting templates for supervisory purposes (known as “FINREP”), and the capital requirements and own funds reporting templates (known as “COREP”), based on the new EU framework for banking regulation under the Capital Requirements Regulation and Capital Requirements Directive (CRR/CRD IV). The aim is to provide supervisors with all relevant information on the financial institutions’ risk exposures, as well as their capital and liquidity positions. Financial reporting forms the basis for regulatory reporting. The main difference between financial reporting and regulatory reporting is the audience: whereas financial reporting is mainly targeted towards investors and creditors, the main addressees of regulatory reporting are banking supervisors. For this reason, financial reporting and regulatory reporting also differ in their “scope of application”: unlike financial reporting, regulatory reporting has a “narrower” focus, meaning that only “credit institutions” and “investment firms” are required to follow these rules.
Let me now turn to the lessons for financial reporting that we have learned from the financial crisis.
Financial reporting forms the basis for various elements of prudential regulation. To take a single example, both the CRR capital ratios and the leverage ratio largely rely on values derived from financial reporting. Moreover, several studies suggest that financial reporting information can influence the behaviour of economic agents, in particular “short-termism” in management’s decision-making. During the financial crisis, at least three accounting practices were cited as potentially obscuring the actual risks of banks and providing adverse incentives to banks:
the excessive use of fair value accounting;
the delayed recognition of credit losses or “impairment charges”;
the inadequate treatment for exposures to “special purpose entities (SPEs)”.
I will briefly address the lessons learned from these three accounting practices.
First, conceptually, fair value accounting allows for the immediate reflection of market perceptions of the inherent values of assets and liabilities and thereby contributes to enhancing “transparency”, since it reveals the effectiveness of management decisions and would make it more difficult for the management of banks and other companies to perform “earnings management”. However, in my view, this is only partially true. One issue is that fair value measurement only provides useful information for certain financial assets and liabilities. A second issue is that the market information that is needed to determine an accurate fair value is not always readily available. For various items, the fair value can only be derived on the basis of models with non-observable input factors. The excessive use of unobservable input obviously reduces both the verifiability and comparability of the results. As a consequence, it is important that fair value accounting is used for those items for which it truly provides useful information, namely for assets and liabilities held in the banks’ trading books and for financial derivatives.
Second, with respect to the recognition of credit losses on loans and debt instruments, the financial crisis has clearly demonstrated that the existing accounting models tend to increase pro-cyclicality. The current approach was developed by accounting standard-setters that were afraid of companies using the loan loss allowance to “manage” their earnings. Therefore, they decided to link the recognition of credit losses to specific observable indicators that signal a default of the counterparty, for example due to significant financial difficulties. However, the existing approach, which is commonly labelled “incurred loss approach”, is still discretionary. Two separate banks may very well reach different conclusions as to when exactly a counterparty’s financial difficulties should be deemed “significant”, thereby requiring the banks to recognise the credit losses. Banks have indeed used this discretion, often doing “too little, too late” with regard to recognising impairment losses.
The third main lesson from the crisis was the inadequate treatment of banks’ exposures to specific entities that were frequently used in structured finance transactions. These entities are known as “special purpose entities (SPEs)”. Exposures to these SPEs can arise in various ways: for example, when a bank commits itself to provide liquidity support to these SPEs in certain circumstances. Prior to the crisis, these exposures were often not properly accounted for.
These lessons led the G20 to request various revisions to the current accounting practices in 2009. In short, the G20 called for changes related to a reform of fair value measurement, the introduction of a more forward-looking approach to the recognition of credit losses, and a review of off-balance sheet financing. In addition, the G20 made the case for more comparability in the area of financial reporting, by requesting the development of a single set of high-quality financial reporting standards.
Now let me summarise briefly what has been achieved so far in these areas with regard to Europe.
State of play
On fair value measurement, the IASB has completed two major projects:
First, in 2011, it released a new standard (IFRS 13, Fair Value Measurement) that provides a general definition of fair value and sets out a consistent methodology for the determination of fair value for all assets and liabilities to which fair value measurement applies. These new requirements are already applicable in the EU.
Second, the first phase of the requested overhaul of the standard for financial instruments (IAS 39) has almost been completed. It deals with the classification and measurement of financial assets and financial liabilities.
With respect to a more timely recognition of credit losses, the IASB is still in the process of finalising an alternative model based on expected credit losses and no longer requiring a specific “credit loss event” or “trigger”. Such a model would undoubtedly be a step in the right direction, with a view to mitigating the pro-cyclical effects of current provisioning practices. However, some issues remain, as Françoise Flores already mentioned in her presentation this morning.
As for off-balance sheet financing, in particular the adequate treatment of exposures to SPEs, the IASB has amended its disclosure requirements for financial instruments (IFRS 7) to encompass additional information on transfer transactions of financial assets, including an understanding of the possible effects of any risks that may remain with the entity that has transferred the assets. In addition, the IASB has fundamentally overhauled its existing guidance for the treatment of shares in other entities (“consolidation”), including joint arrangements, associates, SPEs and other off-balance sheet vehicles. 
The ECB very much appreciates the progress that has been achieved in these areas. We also welcome the IASB’s attempts to better align accounting requirements to existing risk management practices, as evidenced by the new general hedge accounting model that came out recently. All these steps will undoubtedly help to enhance the quality of financial reporting.
There is, however, as usual, a “drop of bitterness”. And this is related to the comparability of financial reporting information, as requested by the G20. After a rather impressive start to the project aimed at establishing a single set of high quality accounting standards, there have recently been some setbacks. On the one hand, US authorities continue to delay the adoption of IFRSs in their jurisdiction. This makes cross-border comparisons of financial reporting information extremely cumbersome, and may affect cross-border activities, mergers and acquisitions and capital-raising. On the other hand, convergence between the IFRSs and their US counterpart, the US Generally Accepted Accounting Principles(US GAAP), has recently waned.
With respect to regulatory reporting, the European Banking Authority (EBA) has made significant progress in improving its existing reporting templates and in developing new ones, in keeping with its mandate under the CRR. For example, new reporting requirements are being introduced for the leverage and liquidity ratios, which will certainly promote further harmonisation in prudential reporting across the EU. However, global comparability also remains an issue for regulatory reporting; it hinges on the regulatory reporting requirements for banks that are applicable outside the EU. More specifically, if the regulatory reporting requirements are stricter for EU banks vis-à-vis their competitors outside the EU, this may put EU banks at a disadvantage and possibly create competitive distortions.
Before concluding, let me turn briefly to my “vision” for the future of financial and regulatory reporting.
Effective communication between companies and stakeholders, including prudential regulators, requires more fundamental reconsiderations than just “piecemeal” revisions to individual financial reporting standards. This has become even more obvious in view of the tasks assigned to the ECB under the SSM.
First, to remain with my earlier “terminology”, where I referred to speaking the same “language”: a language that is understood by, and useful for, all stakeholders – including prudential regulators. It is essential that accounting standard-setters acknowledge the specific role of credit institutions, other financial intermediaries and therefore prudential regulators for the proper functioning of the financial system. To this end, we would urge the accounting standard-setting bodies to add another general requirement to their conceptual frameworks, namely to consider the potential financial stability implications of any revisions to existing accounting standards or of the development of any new standards. Let me briefly explain my rationale. As I said before, one major requirement for accounting standards is that they are useful to investors when making investment decisions. Yet, in the same vein, accounting standards must inform policy decisions of prudential regulators. Credit institutions are fundamentally different from other commercial entities, since a well-functioning banking sector contributes to the efficient capital allocation within an economy, and thereby fosters economic growth and wealth for all. In other words, the public at large benefits when the banking sector is stable, but it also suffers if it fails. It is imperative that this special role of prudential regulators and a well-functioning financial system is explicitly acknowledged as an objective of financial reporting. As you heard earlier today, at the EU level, the Maystadt report, published in November 2013, already includes such a requirement.
Second, it is essential to further identify, analyse and – where feasible – mitigate the potential pro-cyclical effects of financial reporting.
Third, again using my earlier terminology, the global application, or “spread”, of the language I referred to. In other words, the issue of harmonisation remains crucial and needs to be resolved. The ECB continues to promote harmonised financial reporting standards that serve as a basis for regulatory reporting. In this context, let me underline that there is a best solution and a second-best solution.
Best solution: the preferred solution would be, of course, global adoption of the same financial reporting framework. Given their already widespread use, IFRSs would be a natural choice. Unfortunately, this option appears more unlikely than ever, given the US authorities’ reluctance to press ahead with the adoption of IFRSs in their jurisdiction.
Second-best solution: an obvious alternative is to continue eliminating major existing differences between financial reporting frameworks. However, as desirable as this may appear, one thing should be made clear: from an EU perspective, convergence of financial reporting standards must not be pursued “at all costs”. Such an approach would inevitably compromise the quality of financial reporting in the EU. Our main goal is therefore to enhance the quality of IFRSs with respect to transparency, comparability and their effect on financial stability at the EU level.
Fourth, turning now to the specific challenges associated with the establishment of the SSM.
For the near future, there are some specific financial reporting “challenges” in relation to the SSM and the ongoing comprehensive assessment. These challenges relate to the comparability of reported measures.
First, as you know, the ECB will assume its full supervisory tasks under the SSM on 4 November 2014. Before that, all supervised credit institutions are undergoing a comprehensive assessment, which began in November 2013 and will end in October 2014. The comprehensive assessment comprises an asset quality review (AQR) and a stress test. The AQR requires, among other things, common definitions and methodologies, for example, with respect to “non-performing loans (NPLs)” and “forbearance”. Recent analysis has revealed a lack of harmonised definitions of these concepts. Against this background, the EBA published its final guidance on NPLs and forbearance in October 2013. A consistent application of such relevant reporting concepts is key for the SSM to carry out effective supervision.
Second, as I mentioned before, a proper interpretation of the results of key supervisory ratios, such as the leverage ratio, requires the use of comparable assumptions – in this particular context, comparable financial reporting information. However, as not all of the credit institutions within the scope of the CRR are listed companies, they are not all required to apply IFRSs. The use of different accounting frameworks may hamper the analysis of the actual leverage within the financial system, and consequently the selection of adequate micro- and macro-prudential policy responses.
Let me now briefly conclude.
In view of the SSM, adequate “communication” – that is, high-quality financial and regulatory reporting between financial entities and their stakeholders – has become even more important. Reporting can be seen as a language establishing a relationship between management and external stakeholders. To be well understood, both financial and regulatory reporting must be transparent and, thus, useful for their addressees. The relevant accounting standard-setters have made significant progress in enhancing the transparency of various areas within financial reporting, yet more fundamental changes would be desirable. One important step in this regard is the explicit recognition of prudential regulators within the user group of financial reporting, as well as the consideration of potential financial stability implications in the list of objectives of financial reporting.
In addition to transparency, comparability of reporting is essential if we are to achieve the goal of effective communication. From a regulatory perspective, a lack of such comparability impedes the proper interpretation of prudential measures and the development of adequate policy responses. And again, it reminds us of the important role of reporting for prudential frameworks, effective banking supervision and, ultimately, the objective of maintaining financial stability.
Thank you very much for your attention.
IFRS 10 Consolidated Financial Statements, IFRS 11 Joint Arrangements and IFRS 12 Disclosure of Interests in Other Entities.