Commission Services Staff Working Document - possible further changes to the Capital Requirements Directive

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1 Our Ref GTI/AW/NJJ/0809 Your Ref markt-h1 By 4 September th Floor, 338 Euston Road Regents Place London NW1 3BG T F Dear Sirs Commission Services Staff Working Document - possible further changes to the Capital Requirements Directive Grant Thornton International Ltd (Grant Thornton) is one of the world s leading international organizations of independently owned and managed accounting and consulting firms. Grant Thornton International member firms operate in over 100 countries and employ over 29,000 persons worldwide. Grant Thornton welcomes the opportunity to comment on the Working Document and welcomes the discussions about loan loss provisioning which we believe have served to inform the debate about the origins of the economic crisis and procyclicality. Grant Thornton agrees that prime responsibility for preventative action and ensuring financial stability will rest with national bodies, although such actions will be most effective in the European Union if they are coordinated across Member States. Grant Thornton agrees that the Commission Services should assess the aggregate effect of the proposed revisions to capital requirements and their potential impact on financial recovery. In many Member States central banks are seeking to ease the flow of finance to business, and it would seem contrary to that policy if banks were to face a concurrent rise in capital requirements. Accordingly, consistent with the Declaration by the G20 Leaders on Strengthening the Financial System, the revisions discussed in the Working Document and the proposed leverage ratio measure should not be implemented until recovery is assured. We restrict our further comments to the elements of the paper which deal with through-the-cycle expected loss provisioning, and respond to the relevant questions in an Appendix. Counter-cyclical measure to stabilize bank capital The Working Paper implies that regulatory loan loss provisions will become acceptable in general purpose financial statements. In our view it is neither appropriate nor necessary to prejudge the outcome of new accounting standards on loan loss provisioning in the context of developing new requirements for regulatory capital. Prudential requirements for

2 2 regulatory purposes should be distinguished from standards for reporting to investors in general purpose financial statements. Investors are the primary users of financial statements, and they require transparent reporting of a company's results. Grant Thornton supports the International Accounting Standards Board as the primary setter of financial reporting standards because it has support from a broad range of international stakeholders. The Working Document states that loan loss provisioning should not form part of regulatory capital, on the grounds that regulatory capital deals with unexpected losses, and loan loss provisioning deals with expected losses. However, the stabilisation measures are intended to increase capital and so it seems acceptable that they should form another part of regulatory capital. In addition it is not clear from the Working Document why stabilisation measures relating to bank capital need form part of earnings. If this policy is followed we believe there is scope for confusion between regulatory capital movements and earnings. In our view the regulator's method for stabilising a bank's capital can be reported through reserves in the financial statements, and outside earnings, which will preserve transparency of earnings for investors. Loan loss provisioning - methodology standards Section 3.2 of the Working Document sets out five standards that the Commission Services expects would be met by a robust and effective through-the-cycle expected loss provisioning methodology. We have no reason to oppose the five standards as a means for calculating a loan loss provision for prudential purposes. We understand Commission Services' reasons for withholding the right to discretionary provisioning for prudential purposes, and hence the reasons for a formula-driven methodology. Commission Services assume that such a prudential measure (and by implication the methodology) will become acceptable under international accounting standards. However, we do not believe that they will generally represent an appropriate basis for calculating an accounting measure that will form part of earnings because management judgment is an integral element of accounting standards. An accounting measure which is formula driven on a Member State basis is unlikely to be an appropriate earnings measure for application to any given institution when viewed in isolation. Section 3.3 of the Working Document explains two methodologies for calculating the expected loss provision. Each methodology relies on historical information to generate coefficients to complete the formula. The Commission Services anticipate that competent authorities of each Member State should further refine Beta factors by taking into account specific risk characteristics of the debt instruments. It is not clear how a provision will be calculated where there is no historical information for a particular loan instrument, or for a particular loan market within a jurisdiction, across a complete economic cycle.

3 3 In summary, whilst we support the need to revise prudential management in the banking sector, we are concerned that the suggested approach will reduce the quality of financial reporting by credit institutions to investors. If you have any questions on this letter, please contact April Mackenzie (phone: ; or Nick Jeffrey (phone: ; Yours faithfully April Mackenzie Global Head of Public Policy For Grant Thornton International Ltd

4 4 Appendix - section questions We answer the questions on the basis that the stabilisation measures form part of regulatory capital requirements which are not reported as part of earnings. Question 4: The Commission Services suggest that the through-the-cycle value adjustment should not count as regulatory capital (see ANNEX 1, suggested amendment to Article 57). Do you agree? Grant Thornton International response: The through-the-cycle value adjustment is intended to increase the level of regulatory capital, and so it would appear appropriate for the adjustment to count towards regulatory capital rather than being excluded from it. Question 5: Should off-balance sheet items be captured under the formula for through-the-cycle expected loss provisioning, given that "provisions" for off-balance sheet items are not recognised in all relevant accounting standards? Should only assets subject to an impairment test be subject to through-the-cycle expected loss provisioning? (see ANNEX 1, suggested Article 74a(2).) Grant Thornton International response: The effect of changes in off-balance sheet items should be captured under the formula. Question 6: At this point, the suggestion is not to include the option for competent authorities to allow internal methods to determine expected losses across an economic cycle. As an alternative to the regulatory approach to calculate counter-cyclical factors, would it be desirable to allow firms' internal methodologies (to be validated by supervisors)? Grant Thornton International response: Yes. Firms may well have more detailed and relevant information available to them than is available to the competent authority. Question 7: Should the exposure class of Article 86 (ie for credit institutions subject to the IRB approach) be used irrespective of the fact that the credit institution may be under Standardised approach? It may be noted that a mapping between exposures class under the Standardised approach and under the IRB is already used in the prudential reporting system of some member States. As an alternative, should countercyclical parameters be defined for the 16 exposures classes under the Standardised approach? (see ANNEX 1, suggested Article 74a (1).) Grant Thornton International response: For consistency the exposure class of Article 86 might appear desirable. However, we believe that firms should be able use internal methodologies, so firms should also be able to decide, or propose for regulatory validation, the applicable exposure class. Question 8: Please give your views on the following approaches: 1) the Spanish model of through-the-cycle expected loss provisioning; 2) a simplified" Spanish model. In particular, we would welcome views on the relative merits of both options in terms of the building up of provisions in a graduated manner over time (see ANNEX 1, suggested Annex IXb).

5 5 Grant Thornton International response: Both models appear to have the benefit of comparability because there is no discretion available to the credit institution in applying the formula without approval from the national competent authority. However, it could be argued that comparability is lost, because the competent supervisors will be applying a rigid model to a non-homogeneous population of institutions. A major weakness for both models is that they rely on historical data that spans a complete economic cycle. It is not clear what a credit institution should do in the event that there is no historical data for its loan instruments in its market, and it is not clear that all Member States will have the relevant historical data to do what is being proposed. Further, past experience may not be relevant in current circumstances. We acknowledge that building up provisions in a graduated manner over time has its attractions when seeking to facilitate stability. However, if the formulaic provisions are proven to be inaccurate when compared to extant market conditions then fluctuations and instability could conceivably remain. Question 9: Should new risk categories (as suggested above) be introduced along the lines of the Spanish system or, alternatively, should the current risk categories of the CRD (eg credit quality steps in ANNEX VI) be used? (see ANNEX 1, suggested Annex IXb.) Grant Thornton International response: It is not immediately clear to us that formulaic models will be appropriate for new risk categories, especially where relevant historical information is not available. Question 10: Is the "location of the borrower" (as opposed to the booking of the exposure) the right approach, with a view to avoiding regulatory arbitrage? (see ANNEX 1, suggested Annex IXb 2.) Grant Thornton International response: Yes, although this will create a great deal of work for the credit institution and the Committee of European Banking Supervisors. Question 11: Will the data to determine counter-cyclical factors be easily available? Grant Thornton International response: In our view, data will be available in some but not all circumstances. In some circumstances companies have found current market information difficult to establish for all their financial instruments, let alone historical information. We anticipate particular problems for the Committee of European Banking Supervisors in establishing the countercyclical factors for third countries. Question 12: Please give your views on the methodologies for calculating the through-the-cycle expected loss provisions at consolidated level. (see ANNEX 1, amended Article 73.) Grant Thornton International response: Financial reporting disclosures and regulatory provisions should be calculated at the consolidated level.

6 6 Question 13: Please give your views on the scope of disclosure requirements for through-the-cycle expected loss provisioning. (see ANNEX 1, suggested amendment to Annex XII (17).) Grant Thornton International response: The disclosure requirements are detailed and expressed in absolute terms. They would benefit from reference to materiality. Jurisdictions will normally be at different points in the economic cycle, and countercyclical factors will change over time. The Capital Requirements Directive will need to stipulate a reference date (accounting period end?) which will be the date the credit institution will use to establish which countercyclical factors to use in calculating its regulatory loan loss provision.