The Bracken column is named after Brendan Bracken, the founding editor of The Banker in 1926 and chairman of the modern-day Financial Times from 1945 to 1958.
While the current crisis continues to wreak the worst financial havoc seen since the Second World War, it is at best premature and most certainly hazardous to try to draw any conclusions.
Nevertheless, it is possible to put forward some ideas. The first is that nobody foresaw the crisis, with all of its complexities, apart from the odd prophet of doom. The second would confirm the lack of a silver bullet - in other words, there is no single measure or tool that could have prevented the crisis. Finally, despite these difficulties, some lessons are emerging, backed by much consensus, such as the need to reduce the procyclicality of the financial system.
Yet while this goal is widely accepted, an ongoing debate rages, especially between prudential regulators on one side and accounting standard setters and market supervisors on the other, on how best to achieve it. And the debate turns on the use of dynamic provisions. This system - also known as the Spanish provisioning model - requires financial institutions to recognise as impairment in good times loan losses which, on past experience, will materialise later in the business cycle. This allows institutions to report higher profits in bad times. So far, nothing new. Yes, this article is by two Spaniards, but only one of them is a prudential regulator, and the other is a securities market supervisor. Do not expect the usual, recently aired plaudits for Spanish provisioning, but an attempt to build a consensus on this issue.
Schools of thought
Let us start with three basic ideas, for which there seems to be only limited controversy. First, there is a natural divide between accounting territory and prudential territory. Accounting principles should seek to help financial statement preparers determine the profit and loss account in the most meaningful way for users. These are primarily (but not exclusively) investors. But prudential regulators should heed the conditions under which such income is distributed, as this may influence the solvency of financial institutions. Second, the interpretation of provisioning rules in accounting has been too narrow. Banks could have made wider use of the judgmental elements contained in the current accounting principles to make provisions earlier, thereby reducing the effective difference with dynamic provisioning and leading to a less procyclical pattern of accounting income. Third, the rules for calculating impairment under IFRS (International Financial Reporting Standard) and US GAAP (Generally Accepted Accounting Principles) are far from ideal (indeed the whole of financial instruments' accounting regulation, as recognised by the standard setters, is probably far from perfect).
These core ideas can help point towards a reasonably balanced set of co-ordinated actions to be taken by standard setters and regulators alike.
One potentially powerful and feasible step forward in the short term could involve making a transparent distinction between regular profits and distributable profits in public financial statements (along the lines expressed in the March 2009 report by Adair Turner in the UK). Accounting principles - including the chosen provisioning model - would govern, as at present, how the regular profit and loss account is prepared. Regulators would, however, set clear rules establishing which portion of income could be paid out as dividends. The difference between those two concepts of profit would therefore be a set of publicly reported compulsory reserves that would not interfere with the determination of the regular profit and loss account. That set could include a (through-the-cycle) reserve that would be earmarked against future losses and crafted along the lines of the Spanish dynamic provision. Other regulatory measures recently proposed by prudential supervisors, such as reserve valuations for capital gains on complex mark-to-model instruments in the trading book, may also fit the bill.
Static approach
Alongside these changes, although this is probably a more complex and longer-term assignment, standard setters should consider reforming the impairment model, which is based solely on losses already incurred. Naturally, this static approach is relatively simple and straightforward to enforce. However, as expected loan losses are disregarded, preparers typically report as profits income, which is expected to disappear as the cycle matures. Prudential concerns aside, the omission in financial statements of this relevant forward-looking information - which is, in any event, part of a firm's risk-control strategy - can hardly help investors to appreciate the economic reality of the reporting companies. Therefore, standard setters do not need to change their approach to find sufficient motivation to review the treatment of loan losses. Proper risk management and effective investor protection should go hand in hand.
In short, consensus between standard setters and regulators does not seem too difficult to achieve. In this respect, dynamic provisions should be seen as a guiding principle to improve prudential tools with full respect to an investor-oriented accounting system as much as a means to plot a course for the refinement of the impairment rules under a reformed accounting framework.
And, by the way, one should never underestimate the significance and difficulty of a securities supervisor and a solvency regulator reaching agreement in this area, even (or especially) if both are Spanish.
Fernando Restoy is vice-chairman of the Spanish stock market regulator CNMV. José María Roldán is director-general at the Bank of Spain
