IFRS and Basel 2
Ian Michael
Accounting and Auditing Policy Department
Financial Services Authority
Contact: ian.michael@fsa.gov.uk
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IFRS and Basel 2: Key themes
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Widespread adoption of IFRS
Interaction of IFRS with existing regulatory rules
Interaction of IFRS with Basel 2
Disclosure requirements
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Widespread adoption of IFRS
• IFRS increasingly becoming global standards
• Adoption in EU from 2005 (mandatory for group
accounts of listed companies)
• Now used in nearly 100 countries
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EU Experience
• Adoption of IFRS appears to have gone quite smoothly,
even though differences from national GAAPs often
significant
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Typical differences between IFRS and national
GAAPs relevant to financial sector
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Valuation – especially use of fair values
Classification of financial instruments
Hedge accounting
Consolidation
Netting
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Interaction of IFRS with existing regulatory rules
• Definition of regulatory capital
• ‘Prudential filters’
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Definition of regulatory capital
• IFRS (IAS 32) will sometimes indicate a different split
between equity and liabilities than national GAAP
• However, definition of regulatory capital driven to a
considerable extent by the Basel Accord
• Note that regulatory capital includes some elements which
are unquestionably accounting liabilities, eg subordinated
debt
• However, impact of IFRS on measured equity is the key
reason for prudential filters
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Prudential filters (1)
• Cash flow hedges. Under IAS 39, cumulative fair value
gains/losses on hedging instruments are recognised
directly in equity, to the extent hedges are effective
But such gains/losses excluded from regulatory capital
• Application of fair value option to an institution’s
liabilities. Gains/losses arising from changes in an
institution’s own credit risk are excluded from regulatory
capital
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Prudential filters (2)
• Available – for – sale instruments
– loans
– debt securities
– equities
• Own – use and investment properties
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Two important areas of difference between
prudential and accounting treatments
• Securitisations
• Netting
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The Fair Value Option (FVO)
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No prudential filter, but…
Supervisory Guidance on use of FVO by banks
Guidelines and recommended practices address:
(a) Sound risk management and control processes for
banks that utilise the FVO;
(b) Supervisory consideration of banks’ use of the FVO
in the context of evaluating the adequacy of risk
management and regulatory capital
Approach to FVO needs to be set in context of a
supervisor’s overall strategy towards an institution
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Interaction of IFRS with Basel 2
• Most significant issue is the relationship between
accounting loan loss provisions, which under IAS 39 are
based on an incurred loss model, and the Basel 2 concept
of expected loss
• This is discussed in draft Basel paper on ‘Sound credit
risk assessment and valuation for loans’
• Commonality of methodologies and data for credit risk
assessment, accounting and capital adequacy purposes
• Nonetheless, accounting and Basel 2 numbers may differ
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Disclosure requirements
• Enhanced transparency and its contribution to market
discipline has been a major theme in prudential
regulation, and accounting, in recent years
• Prudential response: Pillar 3 of Basel 2
• Accounting response: IFRS 7 – Financial Instruments
Disclosures
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Relationship between Pillar 3 and IFRS 7
• May have different scope
• Audit assurance probably higher for IFRS disclosures
• Pillar 3 emphasises credit risk model embedded within
Basel 2, and in some other respects is more prescriptive
• So Pillar 3 and IFRS are complementary
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