Regulators take aim at unrealised derivatives profits

Accounting changes promoting more fair-value reporting are forcing supervisors to consider radical restrictions on the way banks use profits.

It became a common complaint during the crisis: banks used the vast paper profits created by an asset bubble to pay dividends, bonuses and fund share buy-backs, leaving them weak when the bubble burst.

Now, faced with accounting changes that would result in more financial instruments being reported at fair value through the income statement – meaning changes in value would appear as profits or losses – regulators have been quietly discussing radical new rules that would separate profits into buckets depending on the liquidity of the underlying assets.

The new reporting regime would then allow regulators to restrict how gains on less-liquid instruments are used. As a result, derivatives and structured product businesses could find a huge chunk of their profits fenced away.

Banks already have to use a three-tier hierarchy for all financial instruments that are reported at fair value. Level 1 is for instruments valued using market prices, while level 3 is for instruments where the value is derived wholly from internal models – this is where banks have classified illiquid structured credit assets during the crisis. Level 2, meanwhile, is for instruments that require a mix of market prices and modelling, and is the bucket into which the vast majority of derivatives fall. But this disclosure only provides analysts and investors with an end-of-period snapshot of the value of the assets in each tier, and is buried in the notes to the financial statements. What regulators want to see is a similar tiering applied to profits and placed in the spotlight of the income statement.

That idea appeals to some, but appals others. A US-based accounting specialist with one UK institution reels off a list of practical objections, and concludes: "These people don't know what they're doing."

Assuming a derivative contract is struck at zero, any positive fair value showing up on the asset side of the balance sheet is an unrealised gain ... These numbers are huge

Instant bankruptcy

Surprisingly, perhaps, some regulators agree. Under the most aggressive version of the idea, banks would be barred from counting anything other than level 1 gains towards equity capital - which would exclude the vast majority of positive derivatives fair value and instantly bankrupt any large dealer, says one senior regulator opposed to the plan.

"All derivatives would be out - and those numbers are significant. Assuming a derivatives contract is struck at zero, any positive fair value showing up on the asset side of the balance sheet is an unrealised gain - that is, it has been run through profit and loss but the bank does not have the cash in hand. It's a paper gain, if you will. And if the volume of gains exceeds capital, deducting those gains would leave the bank with negative capital, thus killing it," he says.

As a result, the regulator sent a junior colleague to a Basel Committee sub-group meeting in mid-January armed with a set of figures comparing capital for a number of banks to the unrealised gains they had reported on their derivatives assets. Citi, as an example, had common equity of $71 billion and goodwill of $27.1 billion at the end of 2008, leaving it with $43.9 billion in total - but that compares with $115.3 billion of positive derivatives fair value, the vast majority of which comes from levels 2 and 3, and could therefore be in danger of de-recognition if regulators take a hard line.

"We're hoping this idea goes away, which is why we ran the numbers. A quick look at a few trading banks' balance sheets should have made this idea DOA, but I have had to argue against it several times over the last year, even though it doesn't really pass any test of conceptual rigor," says the regulator.

Reporting shake-up

But a more restrained version of the plan could still constitute a huge shake-up in the way profits are reported - and, depending on how binding the restrictions are, a significant intrusion into board-level decision-making.

Discussions are still in their early stages. Beyond a vague, one-line reference in the Basel Committee's December 17 proposals on reform of bank capital, liquidity standards and risk-taking, there has been no official announcement - but Sylvie Matherat, head of financial stability at the Banque de France and chair of the Basel Committee's accounting task force, told Risk in November that supervisors had held exploratory discussions with accounting standard-setters. Parties to those talks confirm the idea has not gone away.

"It's ongoing. We started talking to various parties - including the Basel people - around the middle of last year," says one London-based accounting source. "We acknowledge the fact there are layers of robustness for fair-value measurements because some aren't based on traded prices - they are marked-to-model instead - and one of the ideas we had for the regulators was that we could separate in the income statement the moves from instruments at levels 1, 2 and 3 of the fair-value hierarchy, which would then give regulators the information they need to do something about it in terms of limiting distributions, bonus payments and so on."

The February issue of Risk contains a feature looking in more detail at regulators' plans for unrealised gains.