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Don’t trim hedges, say banks

Battle lines are been drawn for the soul of European accounting standards. On one side is the French banking community, no doubt supported by bankers right across Europe. On the other is the Anglo-Saxon dominated International Accounting Standards Board which, in March of this year, will be holding public meetings on the issue of financial instruments.

The row is simple, although the technical arguments are complex. Adopting a common set of accounting standards across Europe from 1 January 2005 will require dramatic and costly changes, especially on financial instruments and especially for the banks. Under the IASB’s plan, two types of financial assets currently measured at cost will be measured at fair value. These are derivatives and assets “available for sale” – which are assets that could be sold to meet liquidity needs or in a response to market movements.

The IASB says that fair value is the only way to capture the leveraged and risky nature of these instruments. However, bankers say that they use derivatives to decrease risk rather than to heighten it. Banks currently measure derivatives used in hedging at cost, which for a derivative is often zero. Standard setters have long been suspicious of what they term “special hedge accounting” and have made various attempts over the years to narrow the accounting choices available.

In a bid to stop perceived abuses, the IASB wants to allow hedge accounting only if certain tests are met. The most important of these tests is that the derivative is designated as a hedge of a specific risk at the outset and the derivative is shown to be effective.

Banks are challenging this narrow definition because, otherwise, two strategies commonly used today, namely macro hedging and internal hedging, will not be allowed.

Macro hedging is where the banks hedge a group of items with different risk profiles. For instance, hedging the net interest rate position on a group of assets with different interest bases. Such a hedge fails the IASB test that the derivative hedges a specific risk such as the change in one specific interest base. Experts say that macro hedging can be useless because some items in the group may move in the same direction as the derivative, which rather defeats the purpose of hedging.

Internal hedging does what it says on the tin. A bank may wish to hedge items in the banking book using a derivative purchased from its own trading operation. Nothing wrong with that, but since the bank’s overall risk position has not changed the IASB argues that hedge accounting should not be used.

The opinions are equally divided on assets available for sale. Like hedging they are currently measured at cost and under revamped International Financial Reporting Standards (IFRS) would be measured at fair value. Using cost, argues the IASB, renders comparability between banks impossible because the same asset will be held at different values by different organisations depending upon the date when they were acquired. Also, banks can sell good performers to achieve required returns while leaving poorer ones on their books at more than their present value. The banks say that cost is the right way to measure because they may have no present intention to sell. The IASB recognises that the assets may not be up for sale immediately and so suggests that any gain or impairment in value does not go through the profit and loss account but instead short-term losses are separately reported outside of net profit.

Of course, this is not just about difficult and obscure accounting principles.

Like many other sectors, banks are struggling. The IASB is arguing that financial reports should portray economic reality, even if that’s not very pleasant. It believes that transparency is the only way to promote much needed confidence in capital markets. The banks, however, are arguing that fair value accounting could increase the dubious feel-good sentiment in a bull market or, more relevant today, exacerbate gloom and doom at a time when markets are in crisis.

Given the present state of the markets, it is perhaps not surprising that the banks are suggesting that this is not a good time to adopt such a radical accounting standard on financial instruments. But while delaying this standard beyond 2005 rips the heart out of the IFRS programme, causing such angst amongst Europe’s banks is hardly an attractive proposition either.

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