Financial services companies need to present a consistent picture between IFRS and Pillar 3 disclosures. While this is clearly a tough challenge, there are likely benefits. In particular, exploiting the increasing synergies between the latest round of financial reporting and regulatory reforms could:
- Reduce implementation costs;
- Improve governance; and
- Strengthen confidence
The preparation of risk management information in readiness for IFRS financial statements could be a first step towards implementation of Basel II, and potentially the eventual Solvency II.
In this article we will examine the latest developments in risk and capital management disclosure, the parallels between the various strands and how companies can realise the likely benefits of a more proactive and integrated approach for implementation.
Convergence and the end of the ‘one-size-fits-all’ era
Although IFRS and regulatory reporting serve fundamentally different purposes, the two are becoming increasingly aligned as supervisors and the International Accounting Standards Board (IASB) look to enhance the synergies and reduce potential duplication. This is both a challenge and an opportunity for financial institutions.
The requirements governing financial reporting, regulatory supervision and risk and capital management are evolving and converging.
The mutually-reinforcing three pillar approach envisaged under Solvency II, the planned reform of regulation for insurers in the EU, will be modelled on Basel II, its international banking counterpart. Both frameworks strengthen minimum capital levels (Pillar 1) with a supervisory review process (Pillar 2). This seeks to encourage improvements in risk management by linking regulatory capital requirements to the firm’s internal capital adequacy assessment and to the soundness of its internal control structures. The reforms also aim to improve market discipline by enhancing the transparency of risk and capital disclosure (Pillar 3).
Overall, the two frameworks mark a growing move away from narrow and prescriptive rules towards a broader, more risk and principles-based approach to regulation that focuses closely on the institution’s own assessment and management of the risks facing the business.
At the same time, the IASB has come to recognise risk as an integral element of IFRS financial statements, both in extending the scope of disclosure and in seeking to ensure that what is presented reflects the information used by management.
The alignment between IFRS and its regulatory counterparts has now become even more pronounced with the recent publication of IFRS 7, which updates and augments the core elements of IAS 30, IAS 32 and IFRS 4.
Figure 1 highlights the considerable overlaps between the requirements of IFRS 7 and Basel II. In particular, regarding credit and market risk, most of the qualitative disclosures can be aligned. For instance, the disclosure requirements on risk management policies and processes are comparable. Similarly, there are a number of quantitative disclosures that overlap, such as analyses of credit risk exposures.
There are differences, however: Pillar 3 does not cover liquidity risk and IFRS 7 does not address operational risk.
More subtle differences also exist in the detailed quantitative requirements. For instance, disclosures on the analysis of credit risk exposures under IFRS 7 have to be presented by class of financial instrument, while Pillar 3 requires a classification by exposure class. These differences need to be carefully analysed and managed if companies want to align the two frameworks.
In order to present a coherent and credible picture to the financial markets, there will need to be consistency between the IFRS risk and capital management disclosures and the corresponding Basel II/Solvency II presentation. While this may be viewed as a challenge, institutions have a window of opportunity to exploit synergies that could help to reduce the cost of implementing both sets of requirements.
Realising the opportunities: "The devil in the detail"
Risk management (financial or otherwise), regulatory and financial reporting and investor relations teams need to work together to optimise the synergies between IFRS and Basel II/Solvency II.
In principle, the similarities between the IFRS and Pillar 3 disclosures mean that they can be aligned. In practice, however, this demands care. Substantial adjustments may be necessary to ensure compliance with both sets of requirements. It is crucial to have one, and only one, centralised set of fully reconciled data from which all risk and financial disclosures emanate.
Companies need to be aware that a common approach to the new reporting and regulatory disclosure standards requires a certain amount of care.
Accounting differences
Inevitably, there may be some conflict or at least inconsistency between the description of an entity’s risk profile and the capital positions reported under IFRS on the one hand and what institutions themselves regard as the underlying ‘economic’ position on the other. Typical instances might include the differences between IFRS equity and regulatory capital arising from the IFRS treatment of items such as credit impairments, cash flow hedges or available for sale investments.
Scope differences
Another potential inconsistency could be the differences between the scope of IFRS and that of Basel II. Although the disclosure requirements for banks under Pillar 3 and IFRS 7 are similar, some key variations exist. For instance, although both frameworks focus on the consolidated accounts, Basel II only covers banking business, while IFRS delineates between banking and insurance in a ‘substance over form’ approach, as defined in IFRS 4, whereby an insurer may sell banking products (or ‘investment contracts’). Therefore, financial institutions may have a different distinction between banking (or ‘investment contacts’) and insurance for financial reporting purposes versus regulatory reporting. As a result, institutions may need to produce different disclosures for their consolidated IFRS financial statements and Pillar 3, even when addressing the exact same risk exposure.
Frequency differences
The required frequency of disclosures varies between IFRS and Pillar 3. Companies generally need to present their Pillar 3 disclosures every six months (annually for those subject to the EU Capital Requirement Directive (CRD)), with certain items (notably capital adequacy) required more often. The frequency of different aspects of IFRS disclosure also varies. For example, certain capital information is required in the interim financial statements, whereas other data, such as the reconciliation of changes in the allowances for loan impairment, is not required as often. The systems and verification processes designed to produce information for disclosure under Pillar 3 and IFRS should naturally take account of these differences.
While tacitly recognising that anomalies exist, Basel II states that ‘banks should explain material differences between the accounting or other disclosures and the supervisory basis of disclosure’, though this is not required under the CRD.
A proactive and integrated response to evolving disclosure requirements could cut costs, ease disruption and enhance market credibility.
IFRS 7, Basel II and Solvency II are subject to different timelines. IFRS 7 was issued in August 2005 and its requirements will come into force on 1 January 2007, although earlier adoption is recommended. For those banks that will be applying the Standardised or Foundation Internal Ratings Based approaches, Pillar 1 goes live January 2007, and Pillar 3 should come on stream 12 months later. Although Solvency II is likely to be modelled on Basel II, the wording and a date for its introduction have yet to be decided; it could be 2009 or even 2010 before it is adopted. There is similar uncertainty over the timing of IFRS Phase II, the standard that will eventually govern the measurement of insurance contracts.
If the introduction of Basel II Pillar 3 in 2007 or 2008 might not seem to be an immediate concern, then Solvency II and IFRS Phase II for insurers might appear even more distant. Solvency II and Phase II are developing slowly and it is far from clear how these two projects will interact. While it is interesting to debate how Phase II and Solvency II will develop and interact, these projects do not change the immediate need for insurers to provide sound risk disclosures. Firms would be wise to begin developing a coherent approach to risk management disclosure now, rather than waiting for the outcome of these projects, especially as any drastic change in disclosure once Phase II / Solvency II are finalised could undermine credibility.
Figure 2 below is a high-level portrayal of how IFRS should be considered in conjunction with Basel II and/or Solvency II change programmes. This type of integrated approach would consider IFRS data requirements and business impacts, together with those of Basel II and/or Solvency II. For example, altering an IFRS disclosure may make it consistent with a Pillar 3 disclosure or vice-versa. This type of approach could not only reduce costs, it could ultimately improve risk management governance and provide regulators with a clear and consistent view of the entity’s risk profile and management.
Battle for capital
It is worth bearing in mind that IFRS is designed to increase the comparability between companies across industries and borders. At the same time, competition is increasing as the line between banking, insurance and other financial services sectors continue to blur. As a result, effective risk and capital management disclosures are emerging as a competitive, as well as a compliance, imperative with important implications for share prices and the cost of capital.
IFRS, Basel II and Solvency II represent a common front, which will broaden the scope of disclosure of risk and capital management and is likely to open companies up to ever greater market scrutiny. In particular, the ability to see how risk and capital are managed through the eyes of senior executives will provide valuable insight into the quality of risk management and decision making. Ensuring analysis and information are consistent is essential for maintaining market credibility. This will have important implications for data capture, modelling and investor relations. Companies will also need to look closely at how to make best use of the discretion and autonomy of this principles based approach. While clearly this is a challenge, it could help to optimise the valuable synergies between different projects. Clear and well supported descriptions of the risk profile and its management could also help a particular bank, insurer or bancassurer to stand out from its financial services peers. Ultimately, the best time to provide these insightful risk disclosures is now, beginning with the IFRS financial statements, not once Basel II and Solvency II are finalised.
Charts have been omitted from the online version of this article.
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John McDonnell is IFRS Services Partner with PricewaterhouseCoopers.
Hello,
Nice article, an overview of IFRS and Basel II. Just what I was looking for.
I'd like to know more about this topic. Are there more articles or documents?
Regards,
Nick McDonnell