European Union Council Urges the Reduction of Pro-Cycality on Many Fronts

The Council of the European Union recently underscored the urgency of addressing the fact that the absence of counter-cyclical buffers and the lack of flexibility of accounting rules in allowing for through-the-cycle provisioning have been important factors in the amplification of the financial crisis. The Council announced its support for the introduction of forward looking provisioning, which consists in constituting provisions deducted from profits in good times for expected losses on loan portfolios, and which would contribute to limiting pro-cyclicality. Accounting standards, such as IFRS, currently do not allow for the recognition of expected losses. The IASB is expected to publish an exposure draft dealing with the provisioning issue, including consideration of an expected loss model, by October 2009.

Allowing for the recognition of expected losses would ensure the build up of provisions in good times, reasoned the Council, which can be used in downturns. This scenario would contribute to a better assessment of real profits in good times; adjust managerial incentives in relation to remuneration; make investors more aware of the underlying risks; and further enhance consistency between accounting and prudential rules. In line with the recommendations of the G-20 and calls from banking regulators and the Financial Stability Board to standard setters, the Council urged accounting standard setters to give priority to amending current accounting rules and allowing for more flexibility for provisioning expected losses.

Pro-cyclicality is the term given to the perceived exacerbation of fluctuations on volatile markets by, among other factors, bank capital requirements, accounting standards, and remuneration schemes in the financial sector. A Working Group on Pro-cyclicality mandated by the Council has issued a report presenting potential policy responses to reduce pro-cyclicality in the financial sector. In the meantime, the G-20 has invited international bodies to address pro-cyclicality by mitigating it in regulatory policy and also by reviewing the ways in which valuation and leverage, bank capital, compensation schemes and provisioning practices may exacerbate cyclical trends.

The Working Group’s report focused on four main policy responses with a view to reducing potential pro-cyclical effects of financial regulation and developing counter-cyclical measures. The Working Group called for the monitoring of system-wide risks; the building of counter-cyclical buffers through capital and provisions, the improvement of accounting rules, and the establishment of a sound framework for remuneration schemes. The report centers on developing a macro-prudential approach, by various means, including building in automatic stabilizers into the regulation and providing better information on the basis for discretionary measures and changes in regulation through enhanced monitoring.

The Council supports the need to monitor system-wide risks and to ensure that appropriate tools are in place to further develop macro-prudential monitoring. The Council emphasized that such an approach will only be effective if recommendations based on such monitoring are translated into concrete policy actions where appropriate. A European Systemic Risk Board will be put in place and will have an important role to play in this respect.

While the application of dynamic provisioning will be an important step forward, noted the Council, it may not be enough since provisioning for losses in the loan portfolio may not be sufficiently large and buffers are also needed against fluctuations in the value of financial assets. The Council believes that further work is necessary to mitigate pro-cyclicality by creating counter-cyclical capital buffers, i.e. to be raised in good times and to be drawn down in downturns. It is important that counter-cyclical capital buffers are not perceived as new minimum capital levels when conditions deteriorate and that they do not count towards eligible regulatory capital, so as to allow banks in downturns to draw on buffers previously built up in good times. CEBS and the Basel Committee are working on proposals.

The Council also welcomed efforts by the European Commission to introduce simple non-risk based metrics, which could limit unsustainable balance sheet growth and help in addressing pro-cyclicality.

While recognizing the benefits of the fair value principle, the Council said that the crisis has highlighted that the current valuation of certain financial assets may understate risks in good times and overstate them in downturns. For example, when financial instruments not suitable for fair value are fair-valued, market prices are used when markets are illiquid and modelled prices rely too much on illiquid market prices. The Council said that mark-to-market valuation of many categories of financial instruments should be reviewed and adjusted as appropriate, particularly taking into account the uncertainty of valuations, the reality of the business model of banks, the holding horizons and the actual liquidity of markets.

The Council praised the commitment of the IASB to promptly review the accounting rules on impaired financial instruments. To this end, and to ensure equivalent treatment with US financial institutions, the Council urged the IASB to amend IAS 39 in time for the preparation of the 2009 year-end financial statements. In addition, the Council asked the IASB to perform a more comprehensive review of IAS 39, as a second step, taking into account the objective of achieving global convergence on accounting for financial instruments, as reflected in the G-20 communiqué.

The Council stressed that the remuneration schemes of financial firms have been a source of pro-cyclicality, due to inappropriate incentives, short-termism and inadequate capture of risk. The Council praised the works conducted at the international level by the Financial Stability Board, as well as the CEBS high-level principles for remuneration policy and the European Commission's recent recommendations. The Council urged Member States to implement these recommendations with a view to addressing such shortcomings by strengthening the link between performance and pay, by promoting a balance between long and short term performance criteria, and by enhancing the governance of the remuneration process.

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