He says that thanks to international accounting standards, the extreme leverage of banks in the run-up to the crisis was clear to see. “The fact that market participants chose to ignore this information is one of the most astounding cases of collective dissonance in economic history.”
Hoogervorst, who was giving the key note speech at the inaugural ICAEW and IFRS Foundation Financial Institutions IFRS conference, this morning,also defended fair value accounting, pointing out that where it played a role, it was often beneficial.
“Most banks were exposed to fair value accounting in a limited way,” he said.
“Fair value was mainly limited to the trading book and derivatives. Most people will agree that for such instruments there is no alternative to fair value accounting. Moreover, for the majority of banks, most of their banking book consists of traditional assets, such as loans, which have continued to be measured at amortised cost.”
He pointed out that where banks carried “poisonous” collateralised debt obligations (CDOs) at fair value, they were often more quickly aware of the dangers that confronted them.
“The truth is,” he continued, “that the accounting merely reflected the very real economic volatility that is at the core of the business model of the banking industry.”
Both sides of a bank’s balance sheet are vulnerable. Assets can be sensitive to the economic cycle, while on the liability side, funding can “evaporate with the speed of a mouse click”.
“As if all this is not risky enough, the banking industry has operated on the flimsiest of capital margins,” he added. “Just before the crisis, tangible common equity of many banks was negligible. It was generally only 1% to 3% of the balance sheet, and some banks even had a negative net tangible equity.
“Thanks to our stringent consolidation requirements, the extreme leverage of the banks was there for everybody to see.”
Hoogervorst said that finally the IASB was seeing light at the end of the IFRS 9 tunnel after spending five years struggling with financial instruments. He blamed the complexity of financial instruments and the extraordinary sensitivity of the financial industry for the length of time the standard has spent in being developed.
“Relatively small changes in accounting rules can make a big difference to banks,” he said. “Enthusiasm for greater transparency in accounting is greatly tempered by the possibility of this leading to further bank bailouts! So every change the IASB proposes is subject to intense scrutiny.”
He added that one of the issues holding back IFRS 9 was macro hedging. The board had therefore decided to separate it from the rest of IFRS 9 – which he described as making significant improvements in classification and measurement, general hedging and impairment. “I have no doubt that it will be endorsed around the world.”
ICAEW technical director Robert Hodgkinson described the long gestation of IFRS 9 as “rather tangled and frustratingly slow”.
He said the interaction between accounting standards and bank regulatory capital requirements had also complicated the process. “It is increasingly clear that bank capital ratios are neither as comparable nor as reliable as they should be, irrespective of the accounting treatment.”
He pointed to recent exercises by bank supervisors which highlighted the wide differences in how various bank models would assess the capital requirements for the same hypothetical group of assets.
“Regulatory capital is a key performance measure used by analysts and investors. Banks and banking supervisors are working hard to address the inconsistency in capital ratios. However, until they become more reliable, they threaten to undermine the credibility of the regulatory system.”