Effects of New Accounting and Capital-Adequacy Rules

The new accounting and capital-adequacy rules that came into force on 1 January 2005 and 1 January 2007, respectively, are of major significance to the banking institutions. Both entail new calculation and management methods, and thereby new game rules. This chapter reviews some of the effects of the new accounting and capital-adequacy rules and how they will interact.

The new accounting rules entail that, compared with the previous provisions, write-downs are reduced. According to calculations published by the banks themselves and the calculations in this chapter, the new capital-adequacy rules imply that the banking institutions' calculated capital requirements will decline in monetary terms.

The capital that exceeds the capital requirement constitutes the banking institutions' excess capital adequacy, which can be seen as a buffer in the event of unforeseen losses. The board and management of a banking institution are responsible for ensuring that the banking institution has sufficient capital to meet the risks it faces. The excess capital adequacy held by a banking institution depends on a number of factors, e.g. the banking institution's assessment of the effect of the new accounting rules, the rating agencies' assessment of the banking institution, and its own assessment of the opportunities to procure new capital.

INTRODUCTION

The new accounting and capital-adequacy rules are of major significance to the banking institutions. The accounting rules regulate the banking institutions' reporting and include rules on valuation of the lending portfolio, while the capital-adequacy rules regulate the banking institutions' capital requirements.

New accounting rules entered into force on 1 January 2005. Among other things, the rules entail that provisions for future losses must no longer be based on a prudential principle, but on a neutrality principle. The prudential principle entailed that the banking institutions previously made provisions for losses assessed to be unavoidable (B provisions) and for probable losses (A provisions). In contrast, the neutrality principle entails that the banking institutions may only write down an exposure when there is objective evidence of impairment.

The new capital-adequacy rules, Basel II, entered into force on 1 January 2007. The capital requirements of banking institutions have been changed substantially in relation to the previous rules, Basel I. The requirements are now more institution-specific and to a greater extent reflect concrete risks incurred by the individual banking institution.

Below, the key elements of the two new rule sets are outlined, and their effects are assessed. The focus is on ceteris paribus assumptions, while the implementation in practice will also depend on e.g. the behaviour of the banks. Both sets of rules entail new calculation and management methods, and thus also new game rules. The actual effects of the rules will therefore depend on how the boards and managements of the banks choose to act. The board and management of a banking institution are responsible for ensuring that it has sufficient capital to meet the risks it faces. The excess capital adequacy held by a banking institution depends on a number of factors, e.g. the banking institution's assessment of the effect of the new accounting rules, the rating agencies' assessment of the banking institution, and its own assessment of the opportunities to procure new capital.

THE NEW RULES

Accounting rules
As from 1 January 2005, the consolidated financial statements of all financial enterprises must be presented in accordance with IFRS^[1]. Other financial statements are presented in accordance with Danish accounting rules that are issued by the Danish Financial Supervisory Authority and compatible with IFRS.^[2] All banking institutions may, however, opt for IFRS for both the group and the parent company.

The following focuses on the rules concerning write-downs on loans and receivables.^[3] However, not only the rules concerning write-downs on loans affect the banks' capital, since the accounting rules introduce a large number of other changes that affect the accounts and thereby the capital, but these are disregarded here.

Under the new accounting rules, the valuation of loans is changed. Until now, loans have been stated at nominal value less provisions. Now, they must be stated at amortised cost less any impairment (write-down). Loans are written down when there is objective evidence of impairment, e.g. because the borrower is in dire financial straits or in breach of contract. The loan must be written down to the present value of the expected future payments on the loan, including realisation of collateral.

The new accounting rules entail that write-downs will typically be made at a later time than the provisions under the previous rules. The reason is that provisions must no longer be made for probable losses, but only in the event of objective evidence of losses. This prevents the banking institutions from building up hidden reserves.

Capital-adequacy rules
The new capital-adequacy rules rest on three pillars.^[4] Pillar I specifies the rules for calculation of the minimum capital requirement for credit risk, market risk and operational risk. The most extensive changes are seen in relation to credit risk, where the uniform Basel I rules have been replaced by more institution-specific rules, whereby the capital requirements to a greater extent reflect the risks incurred by each individual banking institution. Operational risk has not previously been explicitly subject to the capital-adequacy rules. In terms of market risk, the new rules differ little from the old rules.

Under Basel II, the banking institutions have a choice of three different approaches to calculation of their capital requirements for credit risk: the standardised approach, which will be applied by the vast majority of Danish banking institutions, the foundation internal ratings based (IRB) approach and the advanced IRB approach.^[5] The following banking institutions have announced in their financial statements that they expect to apply IRB approaches: Danske Bank, Nordea Bank Danmark, Jyske Bank, Sydbank, Alm. Brand Bank, FIH Erhvervsbank, Nykredit Bank and Lån & Spar Bank. The total assets of these banking institutions constitute around 90 per cent of the aggregate assets of the banking institutions in Denmark.

Under Pillar II, the board and management of the individual banking institution must calculate its solvency requirement, which may exceed the statutory 8 per cent. On calculating the solvency requirement, the board and management must take into account the significant risks faced by the banking institution, e.g. earnings capacity, earnings stability, quality of assets, expected future growth, concentration risk, opportunities to procure capital, dividend policy, cyclical factors, strategic risk and reputational risk. The board and management's assessment of the solvency requirement must be discussed with the Danish Financial Supervisory Authority, which can ultimately order the banking institution to hold capital in excess of the statutory 8 per cent.

Pillar III of the capital-adequacy rules contains provisions on the information to be published, e.g. concerning risk, risk management and capital structure. If the Danish Financial Supervisory Authority orders a banking institution to hold capital in excess of the statutory minimum of 8 per cent, there is, however, no requirement to publish this, unless required by a stock exchange, and nor is there any requirement to publish the banking institutions' solvency requirements.

Under the new capital-adequacy rules, the responsibility of the board and management has become more clear. While the capital requirement under Basel I was determined on the basis of mechanical rules, the board and management of the banking institution must now actively assess a number of risks.

Interaction between the new accounting and capital-adequacy rules
The accounting and capital-adequacy rules are two independent sets of rules. The underlying philosophies differ, as do several of the definitions. The capital-adequacy rules are based on " expected loss" , which means that expected future loss events must be taken into account. A default is deemed to have occurred when the banking institution considers that the borrower is unlikely to pay its credit obligations in full, or material credit obligations have been past due for more than 90 days. The accounting rules, on the other hand, are based on " incurred loss" , whereby only events that have already occurred are to be taken into account. There must be objective evidence of impairment before the value of an exposure can be written down. The time horizons in the two sets of rules also differ. Under the accounting rules, the loan must be written down to the current value of all expected future payments on the loan. Under the capital-adequacy rules, the probability of default is, on the other hand, taken to mean the probability of default within one year.

Regarding the interaction between the two sets of rules, the Danish Financial Supervisory Authority writes that there " is an error [in the presentation of the accounts] if a model is based on the use of PD [probability of default] without this probability being adjusted so that it can be used not only for capital-adequacy purposes, but also for accounting purposes" .^[6]

Even though the fundamental philosophies differ, the accounting and capital-adequacy rules are naturally interrelated. If a loan is written down, the banking institution's lending will decrease by the value of the write-down. Under the standardised approach, whereby a banking institution's capital requirement is calculated on the basis of the lending portfolio, write-down of the loan will entail a reduction of the capital requirement.^[7] If the write-downs are lower than the previous provisions, the value of loans under the new rules will exceed the value under the old rules, and the new accounting rules will thus in themselves augment the capital requirement.^[8]

The accounting and capital-adequacy rules are also interrelated via Pillar II of the capital-adequacy rules. The banking institutions must assess the quality of their assets with special focus the on loans that have not been written down in the accounts, or which have only been partly written down. If the quality of the loans is impaired, or the loans are assessed to be undergoing impairment, this must be taken into account under Pillar II. Under the capital-adequacy rules, the Danish Financial Supervisory Authority may order the banking institution to write down its assets, etc. for the purpose of calculation of the base capital under Pillar II. This provision may be applied as an alternative to determining an individual solvency requirement.

EFFECTS OF THE NEW RULES

Accounting rules
The first column of Chart 32 describes the situation at end-2004, before the new accounting rules entered into force. At the end of 2004 the financial statements were presented in accordance with the old rules, with both A and B provisions. Under the old rules, it could be argued that the banking institutions' buffer comprises the excess capital adequacy, i.e. the part of the capital that exceeds the statutory 8 per cent, as well as a large part of the A provisions, i.e. the provisions for probable losses. If this definition is applied, the buffer amounted to almost kr. 100 billion at end-2004 (the yellow and green areas of the first column).

As from the beginning of 2005, when the new accounting rules entered into force, there are no longer A and B provisions, and a loan may only be written down if there is objective evidence of impairment. The new rules were implemented in practice at the beginning of 2005 when the banking institutions prepared new opening balance sheets in compliance with the new rules. The value of loans was written up by an amount equivalent to the reversed provisions, which had a derived positive effect on equity capital. The banking institutions' opening balance sheets show that the difference between the aggregate A and B provisions at end-2004 and the write-downs at the beginning of 2005 is almost kr. 6 billion.^{[9] [10]} The new accounting rules have thus increased equity capital, and thereby the excess capital adequacy, by elements of the amounts that were previously reserved for provisions, without affecting the risk and risk profile.

The situation at the beginning of 2005 is illustrated by the second column of Chart 32, where the banks' buffer now solely comprise the excess capital adequacy.

Since the new accounting rules were implemented at the beginning of 2005, the write-downs have decreased further, cf. Chart 33. This is partly attributable to the favourable cyclical position, and partly to the banking institutions' ongoing adjustment to the new accounting rules.

The actual development from 1996 to 2006 in Chart 33 shows that the banking institutions' buffers as a ratio of loans and guarantees were more or less stable in the period from 1996 to 2003, when the level fluctuated around 7 per cent, and that the buffers have subsequently decreased to around 5 per cent.

Capital-adequacy rules
On 1 January 2007 the new capital-adequacy rules, Basel II, entered into force, albeit with effect from 1 January 2008 with regard to the application of the most advanced IRB approaches. In this section, the effect of the new capital-adequacy rules is quantified by comparing the minimum capital requirement in krone terms under Basel I and the capital requirement under Pillar I of Basel II. Danske Bank, Nordea Bank Danmark, FIH Erhvervsbank and categories B and C are analysed.

Calculations are made of the changes in the minimum capital requirements for credit risk and operational risk, respectively. The minimum capital requirement for market risk is assumed to remain more or less unchanged on the transition to the new rules. In the calculations and the reporting of the results, the effects of Pillar II are disregarded. The fact that banking institutions applying IRB approaches must observe a transitional arrangement is not taken into account either. In 2007, 2008 and 2009, these banking institutions must have base capital at least amounting to, respectively, 95 per cent, 90 per cent and 80 per cent of the base capital that would have been required under Basel I.

Capital requirements for credit risk with regard to banking institutions applying the standardised approach and the IRB approaches are calculated, cf. Box 10. The breakdown of lending to the corporate and private sectors differs for the banking institutions applying, respectively, the standardised and IRB approaches, cf. Chart 34. The latter have relatively higher lending to the corporate sector, while the former have relatively higher lending to the private sector (other). The ratio of lending to the private sector (housing) is virtually the same.

The introduction of Basel II entails an easing of the capital requirement for credit risk for the banking institutions applying the standardised approach, as well as for those applying the IRB approaches.

As a new element, there is also a capital requirement for operational risk. Chart 35 shows how the aggregate minimum capital requirement (Pillar I) under Basel II is changed from the capital requirement under Basel I. The first column in the Chart shows the banking institutions' capital requirements, excess capital adequacy and write-downs at the beginning of 2005, and corresponds to the second column in Chart 32. The second column in Chart 35 shows the calculated effect of the new capital-adequacy rules.

The aggregate reduction of the minimum capital requirement in krone terms under Pillar I is considerable, and totals approximately 35 per cent, which is equivalent to an easing of the capital requirement by around kr. 35 billion. According to the calculations, the reduction of the minimum capital requirement under Pillar I is, on average, in the range of 40 per cent for the banking institutions applying the IRB approaches, and approximately 10 per cent for the banking institutions applying the standardised approach.^[11] All other things being equal, a lower aggregate minimum capital requirement in krone terms will lead to higher excess capital adequacy. It is important to emphasise that this is a ceteris paribus assumption. Even if the capital requirement in kroner (including Pillar II requirements) falls below Basel II, it is not certain that the banking institutions' excess capital adequacy increases. The banking institutions may choose to reduce their excess capital adequacy, e.g. by paying out dividend, buying back shares or increasing lending.

The excess capital adequacy held by the banking institutions is dependent on several factors, including the estimated effect of the new accounting rules and the volatility of the calculated minimum capital requirement. All other things being equal, a banking institution with considerable excess capital adequacy will appear to be more sound than a banking institution with less excess capital adequacy. The banking institution's appetite for risk also plays a role. A banking institution with considerable excess capital adequacy will have time to restructure its activities if earnings fall and the banking institution is therefore approaching the minimum capital requirement. The rating agencies will probably also influence the banking institutions' capital-adequacy decisions, e.g. by requiring a certain excess capital adequacy in order to give a banking institution a certain rating.

WHAT WILL HAPPEN IN A RECESSION?

Accounting rules
Banking activities fluctuate with the economy in general, and the economic situation is reflected in their financial statements. In an upswing, lending often increases, while the opposite effect is observed in a recession.

In periods of high lending growth credit quality often diminishes, leading to higher losses and provisions in the subsequent periods. The financial sector was affected particularly in 1990-94 as a result of the recession in 1987-93. Losses and provisions were exceptionally high in the early 1990s, when average earnings were negative. Since 1996, losses and provisions have been at a low level, and annual profits have been high. The economic downturn in Denmark in 2001-03 did not lead to a pronounced increase in losses and provisions. The reason may be that it was a relatively mild recession, but also that the banking institutions have generally become better at managing their credit risk than they were in the early 1990s.

For some years, the old accounting rules have led to a discrepancy between the losses and provisions for the year and the actual losses, cf. Chart 36. For a number of years, the fluctuations in annual losses and provisions are greater than the actual losses, and the annual losses and provisions are typically recognised earlier than the actual losses.

Under the new accounting rules, a loan cannot be written down merely because the borrower may potentially experience financial difficulties if there is a cyclical downturn. In other words, a recession is not in itself sufficient grounds to write down loans. However, there may be more objective evidence of impairment and thereby financial difficulties for a borrower in a period of economic slowdown. For example, there are often more defaulters in a recession due to rising unemployment.

Looking ahead, it is expected that the new accounting rules will entail a closer correlation between write-downs for the year and actual losses than in Chart 36. In other words, the banks will recognise write-downs at a later stage than the previous provisions, and the fluctuations between write-downs for the year and actual losses will be smaller.

Chart 37 illustrates how in a recession the write-downs under the new rules are expected to increase less than the provisions under the old rules. The comparison of the old and new accounting rules before and during a potential recession is again based on ceteris paribus assumptions.

Capital-adequacy rules
The underlying philosophy of the new capital-adequacy rules is that the banks must hold more capital for high-risk activities, and less capital for low-risk activities. In other words, the rules reflect the specific risks incurred by an individual banking institution. In an upswing, the capital requirement under Pillar I will decrease for the banking institutions that apply the IRB approaches, e.g. if the borrowers' probability of default (PD) declines. On the other hand, in a recession the banking institutions will face higher capital requirements, e.g. if the borrowers' PD rises.

If an increase in the capital requirements has a restrictive effect on lending, the cycle will be amplified in a recession. In contrast, if an increase in the capital requirements does not have a restrictive effect on lending, it is not certain that the cycle is amplified in a recession. Whether the capital requirement has a restrictive effect on a bank's extension of credit is dependent on such factors as its capital objective. If the capital objective is for the bank to hold a certain percentage of excess capital in relation to the statutory requirement, a recession may have an impact on lending, even if the bank holds excess capital adequacy that is well above the statutory requirement.

An analysis of the actual effects of the new capital-adequacy rules requires extensive data work and can, ideally, not be performed until data is available for an entire economic cycle. The ESCB Banking Supervision Committee and the CEBS (Committee of European Banking Supervisors) have set up a working group to investigate the consequences of the new capital-adequacy rules.

Chart 38 shows the calculated effect of a 2-year recession scenario in which all PDs for Danish companies migrate one class downwards in the first year and once again in the second year. It is, perhaps, not very likely that all borrowers are downgraded, but the example has deliberately been simplified.

In order to be resilient to the 2-year recession scenario, the excess capital adequacy for credit risk on the corporate portfolio must be around 25 per cent higher than the calculated minimum capital requirement for credit risk on the corporate portfolio under Pillar I.^[12] The effect on the aggregate capital requirement is shown by the last column in Chart 39. A larger kroner amount is now required to observe the 8-per-cent capital requirement. This is taken from the excess capital adequacy.

Overall, the expected effect of the change from the old to the new accounting and capital-adequacy rules can be illustrated by the difference between the first and the second columns in Chart 40. The first column shows the situation under the old accounting and capital-adequacy rules, while the second column shows the situation under the new accounting rules, cf. the opening balance sheets at the beginning of 2005 and the calculated new capital requirement. The expected, stylised, ceteris paribus change in a recession scenario is illustrated by the third column in Chart 40. Once again, it should be emphasised that Chart 40 shows the potential effects without taking any changes in the banks' behaviour into account.