Marking-to-Market or Marking-over-the-Market? The Influence of Measurement of Financial Instruments at European banks on Procyclicality

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Marking-to-Market or Marking-over-the-Market?

The Influence of Measurement of Financial Instruments at European banks on Procyclicality

Henk-Jan Nanninga

University of Groningen, Faculty of Economics and Business Master thesis Accounting

Version: 15 February 2010

Abstract

This master thesis studies the relationship between measurement of financial instruments and procyclicality. It is investigated whether changes in measurement, fair value changes, impairment charges, reclassifications, changes in valuation methods and changes in off-balance sheet investments contribute to procyclicality in the financial system.

I discuss the current IFRS regulation starting with how fair value is defined under IFRS and explaining current standard on presentation (IAS 32), recognition and measurement (IAS 39) and disclosure of financial instruments (IFRS 7). Furthermore I discuss recent amendments to IAS 39 and IFRS 7 by the IASB (i.e. ‘reclassification of financial assets’ and ‘improving disclosures on financial instruments’). Additionally I discuss the recently issued IFRS 9 which will succeed IAS 39 on classification and measurement. Finally I present IAS 27 ‘consolidated and separate financial statements’ and SIC 12 ‘consolidation – special purpose entities’, to the extent these standards covers off-balance sheet investments, including the ED IFRS 10 that is to replace IAS 27 and SIC 12.

The accounting difficulties imposed by procyclicality are studied. Additionally the accounting difficulties imposed by Illiquidity are also studied as it is found to be a main source of procyclicality. The results from the empirical study on 38 European banks are used to investigate the relationship between measurement of financial instruments and procyclicality. Based on the outcome of the empirical study I conclude that the overall accounting framework does not contribute to procyclicality in the financial system. Furthermore I propose and evaluate policy recommendations on how accounting can be used to measure financial instruments given the relationship between measurement and procyclicality.

Classification: Master thesis

Keywords: Financial instruments, Procyclicality, Fair Value Accounting, Historical Cost Accounting, Illiquidity, Financial Crisis, Banks, Off-balance sheet accounting, IAS 27, IAS 32, IAS 39, IFRS 7, IFRS 9, IFRS 10 and SIC 12.

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Marking-to-Market or Marking-over-the-Market?

The Influence of Measurement of Financial Instruments at European Banks on Procyclicality

Author Henk-Jan Nanninga

Student Number S 1462539

Email nanningahj@gmail.com

University University of Groningen

Faculty Faculty of Economics and Business

Master MSc Accountancy

Supervisor University of Groningen Drs. J.L. Bout

Prof. Dr. R.L. ter Hoeven RA Supervisor Ernst & Young Drs. Jan-Willem Miedema RA

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Preface

During the past two years bankers, politicians, journalist, professors, you and I have been witnessing the occurrence of a financial crisis that is said to be the largest in the history of mankind. We all have been discussing possible causes, the expected impact of the crisis or predicted when the crisis will come to an end. During my entire studies in Groningen I have never experienced such a lively debate concerning our economy or any topic related to accounting. No wonder that when I had to choose a topic for my master thesis I started looking for something connected to the financial crisis, which grabbed the attention of all of us.

I chose to study the influence of the accounting rules on the development of economic cycles, which is referred to by the concept of procyclicality. In case of procyclicality reported profits exceed expected profits and reported losses are lower than expected. In other words economic upturns and economic downturns are exaggerated which increases times of economic prosper but also increases the length and severity of economic downturns. Therefore the topic investigated in this thesis affects the life of all of us, as the ongoing lively debate nicely illustrates. However before I will address this issue I want to thank a number of people to whom I owe great thanks for their help in the process of writing my thesis.

First of all I want to thank Bert-Jan Bout, my supervisor at the University of Groningen, for his numerous comments, his late night emails, the ‘private lecture hours’, his feedback rounds and his suggestions for investigating the matter. I have really enjoyed our sparring sessions and I especially want to thank you for being a very committed and motivating supervisor. Besides, I am still thankful for your tips regarding Coldplay concert that helped me gain a tremendous spot in the audience.

Prof. Dr. Ralph ter Hoeven, attended much of the sessions that Bert-Jan and I had and therefore I owe him great thanks also. Especially for sharing his ideas and his great academic - and analytical skills that have helped me to frame the complex subject of my thesis. It was also a great pleasure to work with both Ralph and Bert-Jan on another paper that has received a lot of attention in the accounting profession and media.

Furthermore I am thankful to Ernst & Young for offering me the opportunity of an internship and providing me with all the resources needed for the writing of my thesis, both intellectually and materially. Of all my colleagues at the FSO department I especially want to thank Jan-Willem Miedema and Hildegard Elgersma for being my coach and supervisor during my internship. Their feedback helped me to understand the practical relevance of the topic investigated and the discussions with my colleagues really helped me to gain a better understanding of the topic investigated.

Of course I want to thank my girlfriend Jaline, for never being bored when listening to all the stories about my thesis and my experiences during the internship and for preparing the quick dinners before I had to go to class. I also want to thank my roommates Zwier and Hendrik and my other friends for their

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understanding when my time balance shifted to a working regime and I spend most of my time either at the office or in class.

Last but certainly not least, I want to thank my family and my parents who always supported me and motivated me to focus on what I am good at, as well in high school as during my university career in Groningen. You all have helped me to become the person I am right now, for which alone I want to thank you already. During my studies in Groningen and even when I was far away in China, you have all felt very near. I can never thank you enough for your care and support, therefore I will continue to do so.

Now I will move on to address the relationship between the field of my studies, accounting, and the global financial crisis that is all around us. I do not claim to answer all the questions posed in the first few lines of this preface. But I do promise that this thesis provides understanding of the relationship between accounting for financial instruments and the severity of the financial crisis.

Although I am not finished studying yet and will continue to study philosophy, this thesis marks the end of my studies in accounting at the University of Groningen, at least temporary. I never expected that writing a thesis could be so much fun and as interesting as I have experienced during the past 5 months. I hope you enjoy reading this thesis as much as I enjoyed writing it.

Groningen, 12th of February 2010 Henk-Jan Nanninga

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Chapter 1 – Introduction

The financial crisis has left its footprint on our economy, especially due to the impact of the crisis on the banking sector. The Bank of International Settlements (2009, P. 1) describes that many banks had build up excessive leverage both on and off-balance at the beginning of the crisis. When the financial crisis hit these banks, their liquidity buffers were not sufficient to withstand the impact of such a shock. A procyclical process of deleveraging began, that was enforced by the credit losses of both on and off-balance sheet investments. The market lost confidence in the liquidity of banks capital, and when the financial crisis transmitted from the banks to the rest of the economy liquidity dried up even further. Government interventions were needed to prevent the collapse of banks, insurance companies and other companies, resulting in losses for taxpayers.

The financial crisis forces us to reinvestigate existing valuation and accounting methods for financial instruments. In the current financial crisis some banks were forced to sell assets leading to a downward pressure on market prices. Under Fair Value - and Historical Cost Accounting these prices or related market variables are used as an input for the measurement of financial instruments. When the prices of financial assets kept going down, so did the value of financial instruments.

After the financial crisis in the eighties, historical cost accounting became more and more criticized, as it did not provide sufficient relevant information prior to and during the financial crisis. In the current financial crisis fair value accounting is blamed for enforcing Crouhy (2008), or even causing, Trussel and Rose (2009) the financial crisis. They point towards the difficulties that arose in illiquid markets in estimating the fair values of financial instruments and state that measurement at fair value is subject to procyclicality. Historical studies on the nature of financial crises show that in general crises are characterized by the co-occurrence of procyclicality and illiquidity, Schnabel and Shin (2004). This conclusion is supported by the IMF (2008) and Veron (2008, P. 3). However, in looking for explanations of the current financial crisis and the crisis of the eighties opposite causes are identified.

To provide insight in the influence of measurement of financial assets on procyclicality I conduct an empirical study on 38 European banks. It is investigated whether the extent and amount of changes in the value of financial instrument as a result of fair value gains or losses, impairment, reclassification or valuation method may indicate procyclicality. For the same banks the influence of changes in off balance sheet exposure on procyclicality is studied. (Proposed) changes in IFRS are studied and compared to current financial reporting standards. Illiquidity is found to be the main factor contributing to procyclicality and as such it is studied how to measure financial instruments in illiquid markets.

1.1 Relevance

This study studies all indicators that influence the value of financial instruments given their measurement basis, and relates these factors to procyclicality. The value of a financial instrument may

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change during the holding period of the instrument. How these changes are treated depends on classification of the financial instruments. Depending on classification, financial instruments are either measured at fair value or at amortized cost. The process of classification and measurement of financial instruments is described in paragraph 2.2. It is investigated how fair value accounting and historical cost accounting record changes in the value of a financial instrument. Ten categories of changes and their indicators are identified that show the impact of these changes. A significant (change in) value or a significant value in terms of profit before tax or total equity may indicate a procyclical effect and it is investigated whether this is indeed the case.

In my study on the influence of measurement on procyclicality I thus focus on both fair value accounting and historical cost accounting. This in contrast to previous research conducted by the IMF (2008), FCAG (2009), FSF (2009) the ECB (2004), Bout et al (2010), who all focused on fair value accounting.

This thesis contributes to existing literature on the relationship between measurement and procyclicality since new indicators for procyclicality are investigated. While working on this thesis, I contributed to the empirical study conducted by Bout et al. (2010). In that study fair value exposure is used as an indicator of procyclicality for the years 2007 and 2008, I will expand this analysis for the first half of 2009. Furthermore I add two additional parameters that may indicate procyclicality: fair value income and impairment under both fair value and historical cost accounting. Finally I present the influence of reclassifications on the measurement of financial instruments.

Additionally, this thesis contributes to the existing accounting literature by studying the impact of off-balance sheet exposures. Changes in the value of financial instruments that are carried off-off-balance do not affect the balance sheet directly but these changes may indicate a procyclical effect. If off-balance sheet investements do not longer meet this definition as a result of changed economic conditions these investements are to be carried on balance, exposing the balance sheet to value changes in these investements, FSF (2009, P. 26).

Most studies so far have used a theoretical perspective on the relationship between measurement and procyclicality, Hitz (2007), Plantin et al. (2008). Others have tried to establish a target situation against which potential procyclicality can be measured, for example the studies conducted by the IMF (2008), SEC (2008) and the ECB (2004). My research however does not use a, potential limited, benchmark situation but instead I focus on reported changes in the value of financial instruments.

In the empirical study conducted, I use data for Europe’s 38 largest banks ranging from January 2007 until June 2009. The period investigated covers the period in which the current financial crisis occurred. This provides relevant insight in the developments on banks’ balance sheets and statements of comprehensive income during the financial crisis. This insight enables me in identifying factors that may contribute to procyclicality and furthermore facilitates the development of policy recommendations to mitigate potential procyclical effects.

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This is the first study that investigates how the measurement of financial instruments may differ between ‘system banks’ and other banks. This distinction is made based on a list published by the Financial Times (November 2009)1_{that contains the names of financial institutions of which failure} would have a severe impact on the world economy. In my empirical study I analyze whether the measurement of these system banks actually has a significant impact on procyclicality and the financial system.

My thesis is relevant for policymakers since I provide recommendations on how accounting can be used given the relationship between measurement and procyclicality. My thesis is relevant for standard setters since it increases insight in the relationship between the current accounting framework and the real economy. Regulatory bodies are provided with insight in how changes in the value of financial instruments may affect financial stability, they may use the recommendations presented to improve regulatory control. Accounting firms benefit from this thesis since it provides insight in the structure of balance sheets of major European banks. It is for these reasons that investors also benefit from this thesis.

1.2 Research Questions

To investigate the critique and to determine the relationship between fair value and the financial crisis, especially on the subjects of illiquidity and procyclicality, I pose the following main research question:

Has measurement of financial assets and liabilities by European banks contributed to procyclicality in the financial system?

By answering this question we can investigate whether accounting for financial instruments by European banks influences the stability of the financial system. The answer to this question thus enables us to identify recommendations on how to increase financial stability and clarifies how measurement of financial instruments may contribute to this stability.

To establish the relationship between the measurement of financial assets and liabilities and procyclicality, the following eight sub questions are posed:

1. How are financial instruments measured under IFRS and how may (proposed) amendments change this?

2. What is the relationship between procyclicality and illiquidity and the financial system?

3. How do European banks measure financial instruments and how sensitive are balance sheets of European banks?

1_{The article in the Financial Times (2009) was based on a list obtained from the Financial Stability Forum, containing several}

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4. Do changes in the value of financial instruments reflected in income or other comprehensive income indicate procyclicality?

5. Do changes in measurement, following reclassification of financial assets during 2008, indicate procyclicality?

6. Do changes in off-balance sheet investments and exposure indicate procyclicality? 7. Do changes in valuation methods indicate illiquidity?

8. Does measurement of financial instruments at system banks have a significant impact on

procyclicality and the financial system, compared to non-system banks?2

What these questions aim to answer is described in paragraph 1.4.3_{How this questions will be answered} is described Chapter 4.4

1.3 Conceptual Framework

In this section I explain the concepts and their mutual relationships as displayed in this conceptual framework. The conceptual framework for this thesis is depicted below in Figure 1. Concepts in the black frames are the six parameters of procyclicality investigated in this thesis.

The numbers 1 to 6 refers to the six indicators of procyclicality studied in this thesis. Arrows represent the nature of the relationships between concepts; numbers are also used to refer to these relationships. Dotted relationships are studied in this thesis. Paragraph 1.3.1 defines the concepts, paragraph 1.3.2 defines the relationships depicted of the framework.

2

System banks are the twelve banks that are both in my data sample and in the article of the Financial Times (2009).

3_{Paragraph 1.4 Goal and Scope of this thesis.}

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1.3.1 Description of the concepts

The central question in this thesis is whether measurement of financial instruments contributes to procyclicality. MEASUREMENT refers to which accounting method is used for the valuation of a financial instrument. Under the current regulatory framework (IFRS) this can be either FAIR VALUE ACCOUNTING or HISTORICAL COST ACCOUNTING. How instruments are measured is prescribed by the IASB in IAS 32, IAS 39, IFRS 7 and the newly issued standard, IFRS 9. Due to amendments to IAS 39 and IFRS 7, RECLASSIFICATION is now possible for certain financial assets, enabling a change in MEASUREMENT, for example from FAIR VALUE ACCOUNTING to HISTORICAL COST ACCOUNTING.

Under FAIR VALUE ACCOUNTING, CHANGES IN FAIR VALUE are recorded in either the profit or loss account or in other comprehensive income. Financial instruments recognized as available for sale are measured at FAIR VALUE and may be subject to IMPAIRMENT.

Following amendments to IFRS 7, from the first of January 2009 entities are required to disclose in a level hierarchy the VALUATION METHOD used for the valuation of financial instruments, including changes in valuation methods used. Changes in VALUATION METHOD may indicate ILLIQUIDITY which is identified to be an important source of PROCYCLICALITY.

Financial instruments measured using HISTORICAL COST ACCOUNTING may be subject to IMPAIRMENT during the holding period. These impairments are recognized as a loss in the profit or loss account. Off-balance sheet investments are not recognized on the balance sheet of financial institutions but the amount carried off-balance may change over time. An indicator for the OFF-BALANCE SHEET EXPOSURE is the difference between off-balance assets and liabilities. Off-balance sheet exposure may change as changed economic conditions may no longer permit an entity to carry an investment off-balance. Changes in the value of financial assets and or liabilities, carried balance also influence the off-balance sheet exposure.

A financial crisis can be seen as the co-occurrence of both PROCYCLICALITY and ILLIQUIDITY where both are reinforcing each other, IMF (2008); Veron (2008, P.3); Shnabel and Shin (2004). As such ILLIQUIDITY is depicted in the conceptual framework as it does impose severe accounting difficulties. All of the mentioned concepts fall within the FINANCIAL SYSTEM that is depicted, surrounding the other concepts. Part of the FINANCIAL SYSTEM are SYSTEM BANKS and non-system banks.5_{It is investigated to what} extent measurement of financial instruments at SYSTEM BANKS, influences PROCYCLICALITY.

1.3.2 Parameters of procyclicality studied in this thesis

For the six concepts depicted in the black frames the relationship with procyclicality is investigated. These concepts form the six parameters of procyclicality investigated in this thesis. MEASUREMENT (1) is the key parameter investigated in this thesis. Furthermore it is investigated whether CHANGES IN FAIR VALUE (2), changes in VALUATION METHOD (3) that indicate illiquidity, IMPAIRMENTS (4), OFF BALANCE SHEET EXPOSURE (5) and RECLASSIFICATIONS (6) may give rise to procyclical effects. In paragraph 1.3.3

5

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these relationships are further explained. In paragraph 4.2 the parameters are linked to categories of change and their indicators which are investigated empirically, in Chapter 5 of this thesis.

1.3.3 Relationships studied in this thesis

To investigate whether measurement of financial instruments contributes to procyclicality the relationships (R) numbered 1, 2, 3, 3a, 4, 5, 6, 7, 8 and 9 are studied in this thesis. R1 refers to the main research question on the relationship between MEASUREMENT of financial instruments and PROCYCLICALITY. The other relationships depicted are investigated to conclude on the nature of R1. The amount and extent of FAIR VALUE CHANGES may indicate a procyclical effect, shown by R2. R3 shows that market ILLIQUIDITY may be signaled by changes in VALUATION METHODS. Market ILLIQUIDITY in turn is a main source of PROCYCLICALITY shown by R3a. IMPAIRMENT of financial instruments measured at amortized cost or recognized as available for sale and measured at fair value, leads to a change in value which may be procyclical, shown in R4 and explained in paragraph 5.2.2. Changes in off-balance sheet investments do not affect the balance sheet or the profit or loss account but may affect the OFF-BALANCE SHEET EXPOSURE and may have a procyclical effect, shown by R5 and explained in paragraph 5.5. R6 shows that RECLASSIFICATION of financial instruments influences the MEASUREMENT of financial instruments and may produce changes in value that may have a procyclical effect.

In studying relationships 2, 3, 3a, 4, 5, and 6 the relationship 1 between MEASUREMENT and PROCYCLICALITY can be established. This also provides insight in relationship 7 and 8 to what extent MEASUREMENT respectively based on FAIR VALUE ACCOUNTING or HISTORICAL COST ACCOUNTING contributes to PROCYCLICALITY. R9 studies the impact of measurement of financial instruments at SYSTEM BANKS on PROCYLICALITY.

1.4 Goal and Scope of this thesis

This thesis aims to establish the relationship between the measurement of financial instruments and procyclicality. The Financial Crisis Advisory Group (2009, P. 4) concludes that accounting standards are not procyclical. Financial instruments measured at fair value may be undervalued but this is offset by overvalued financial instruments measured at amortized cost and obscured losses from off-balance sheet investments. I empirically investigate this claim in a study on 38 European Banks by studying six parameters; changes in value reflected in income or other comprehensive income; changes as a result of impairment; changes in valuation method based on the fair value hierarchy that indicate illiquidity; changes in off balance sheet investments and changes in measurement. Furthermore I present the changes in measurement of financial instruments as a result of reclassifications. These six parameters correspond to the concepts depicted in the black frames in figure 1.6_{In the existing accounting literature} several other parameters for procyclicality are identified that will be discussed in paragraph 3.4.3. It is

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my opinion that the parameters presented provide sufficient information to study the relationship between measurement of financial instruments and procyclicality.

Although I study the influence of measurement on procyclicality I do not enter in the ongoing debate in literature between fair value accounting versus historical cost accounting. I will not judge the applicability of these accounting systems for the measurement of financial instruments, that are within the scope of IAS 32 and IAS 39. The elements of fair value accounting and historical cost accounting relevant for this thesis are described but no attempt is made to compare these two accounting methods. However, I do form recommendations on how to use accounting to measure financial instruments given the nature of the relationship with procyclicality. As procyclicality and illiquidity are interconnected I will also form recommendations on how to account for these difficulties.

The data sample used, in the empirical part of this thesis, consists of the 38 largest European banks. My sample is based on the banks present in the FTSE Eurofirst 300 Index at the end of January 2009. Although information regarding measurement for insurance companies, broker dealers, credit institutions and real estate companies may also be relevant these are not discussed in this thesis. I choose to focus on the 38 largest European banks to increase the uniformity of the conclusions of this study. In paragraph 4.3 I present how the data sample is composed.7

It is investigated for a period starting the 1th of January 2007 and ending on the 30th of June 2009 whether the six parameters defined do indicate procyclicality. I am aware that by not including the full year figures of 2009 I do limit the implications of my research but my results show that data obtained from the 2009 interim statements does provide relevant information regarding the measurement of financial instruments.

1.5 Structure

This paragraph describes how the remainder of this thesis is structured. Chapter 2 provides the institutional framework for this thesis. The accounting policies relevant for the measurement of financial instruments are described starting by defining a financial instrument as described in IAS 32 ‘Financial Instruments’: Presentation. Thereafter the important concepts, including measurement bases, from IAS 39 ‘Financial Instruments: Recognition and Measurement’ are presented. The classes of financial instruments are described including how changes in value are accounted for.

The accounting methods used for the measurement of financial instruments are discussed based on the definitions and guidelines provided by IAS 39. The estimation of the value of a financial instrument under both fair value accounting and historical cost accounting are central elements in this paragraph. The reclassification amendments are studied showing the impact that reclassifications may have on banks’ balance sheets. IFRS 7 ‘Financial Instruments: Disclosures’ is discussed especially with respect to the

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2009 amendments regarding disclosures relating to the fair value hierarchy and on reclassifications of financial assets.

The requirements for consolidation of Special Purpose Entities or off-balance sheet treatment are presented in an analysis of IAS 27 and SIC 12. The new standard, IFRS 9: Financial Instruments, is presented and the major differences with current IAS 39 are discussed. The discussion focuses on the changes in categories recognized for the measurement of financial instrument. The Exposure Draft to IAS 39 (2009) proposes a change in impairment procedure from incurred loss to expected loss model which is briefly discussed. Finally, Basel II is introduced since it provides guidelines for capital buffering by banks. These reporting standards and financial frameworks make up the institutional framework relevant for this thesis.

Chapter 3 moves on discussing procyclicality and illiquidity. Procyclicality is defined and a literature review is presented providing the different natures of procyclicality. Reports on procyclicality and fair value are summarized and issues regarding accounting and procyclicality are exposed. Factors contributing to procyclicality are also presented. Illiquidity is found to be the main source of procyclicality and as such is discussed in more detail in the remainder of chapter 3. Illiquidity is defined and the main difficulties it imposes on accounting are presented. Finally, the different views on decision usefulness of accounting in case of illiquid markets are presented.

The research design is presented in chapter 4, presenting the methodology used to address the main research question and the sub questions posed in paragraph 1.2. I present the composition of the data sample and the methods used for data interpretation are described including their limitations. The results of this study are published in chapter 5, starting with the descriptive statistics of the sample. Thereafter, each paragraph of chapter 5 corresponds to a sub question that is addressed empirically. Comparisons are made between the outcomes of this empirical study and previously conducted research, if available. In the final section of the paragraphs results are related to the sub questions presented in paragraph 1.2 and chapter 4.

The conclusion on the main research question is addressed in chapter 6 based on the results of sub questions 3 till 8 investigated empirically in chapter 5, and the qualitative analysis of sub question 1 and 2 in respectively chapter 2 and 3. In presenting my conclusions I make a distinction between measurement at fair value, measurement at amortized cost and the impact of changes in off-balance sheet investments on procyclicality.

Based on the results of my qualitative analysis in Chapter 2 and 3 and my empirical results I provide policy recommendations on the use of measurement in Chapter 7. I evaluate policy recommendations found in literature on the basis of the empirical results of this thesis. Finally I present the recommendations for future research in Chapter 8, based on the limitations of my thesis.

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Chapter 2 – Institutional Framework

This chapter contains the rules and regulations that entities, are subject to with regard to classification and measurement of financial instruments, following sub question 1 posed in paragraph 1.2. I start with an introduction to IFRS explaining current standards IAS 32 ‘Financial Instruments: Presentation’, IAS 39 ‘Financial Instruments: Recognition and Measurement’ and IFRS 7 ‘Financial Instruments: Disclosures’. Furthermore I introduce the recent amendments to IFRS 7 and present IAS 27 and SIC 12 as these standards cover treatment and disclosures on off-balance sheet investments. Additionally I present the (proposed) changes to IAS 39. I end with a description of Basel II, introducing the relevant concepts for this thesis.

2.1 IAS 32 Financial instruments: Presentation

IAS 32 covers the classification of financial instruments into financial assets, financial liabilities and equity instruments. Classification of financial instruments depends on the economic reality rather than the legal form of a financial instrument,[IAS 32.15]. IAS 32.18 prescribes that the components of the financial instruments are used to classify the financial instrument. This classifications takes place at the moment that the financial instrument is recognized on the balance sheet. At that moment it is also determined whether the instrument is recognized as debt or equity. This classification cannot be changed in future periods, [IAS 32.15 and 32.18].

IAS 32 also defines the concept of financial instrument. This definition refers to the concepts of financial asset, financial liability and equity instruments, which will subsequently be defined. The standard also provides guidance on how these definitions should be applied. IAS 32 thus categorizes financial instruments in either financial assets, financial liabilities or Equity instruments.

2.1.1 Financial instrument

In IAS 32 the following definition of a financial instruments is depicted:

Any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument in another entity. [IAS 32.11]

The presence of a financial instrument thus requires the presence of two entities. One entity serves as a debtor the other entity is the creditor for the financial instrument. A financial instrument that is carried on the balance sheet is carried as a financial asset on the debit side by the debtor. In that case the creditor carries the financial instrument on the credit side of the balance sheet as either a financial liability or an equity instrument. Ernst & Young (2009, P. 2040) states that a contract should be seen as an agreement between two parties that is enforceable by law, and thus the parties are bound by the contract.

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The definition of financial instrument does also apply to some investments that are not in the scope of IAS 32 and 39, [IAS 32.4] such as leasing or employee benefit plans. These financial instruments are not included in the scope of this thesis.

The definitions of financial assets, financial liabilities and equity instruments provide more a more detailed description of these financial instruments and as such will be defined in the subsequent paragraphs.

2.1.2 Financial asset

A financial asset is defined as any asset that is: ‘cash, an equity instrument of another entity, a contractual right or a contract that will or may be settled in the entity’s own equity instruments’ (IAS 32.11).

A financial asset as an equity instrument in another entity, clearly relates back to the definition of a financial instrument as described above. In the case of cash the entity is holding the cash on the debit side of the balance sheet and another entity, a bank for example, holds the cash on the credit side of its balance sheet.

IAS 32 contains further guidelines for financial assets in the form of contractual rights or contracts. A contractual right is present if the entity holds the right to receive cash or another financial asset from another entity. Another option under which a contractual right gives rise to a financial asset is when a contract exist that enables the entity to exchange financial assets or financial liabilities with another entity. IAS 32 provides the condition that the exchange must be potentially favorable for the entity itself. Finally a financial asset may also consist of a contract that will or may be settled in the entity’s own equity instrument, and is either a derivative or a non derivative. For a non-derivative an entity may be obliged to receive a variable number of the entities own equity instruments. In case of a derivative contract the exchange of a fixed number of equity instruments is not settled by cash or another financial asset. When this is the case an entity’s equity instruments do not include puttable equity instruments.

2.1.3 Financial liability

Financial liabilities contain a contractual obligation, thus opposite to the contractual rights as a characteristic of financial assets. A financial liability is either a contractual obligation or a contract. IAS 32 thus makes the same distinction for both financial liabilities and financial assets.

The contractual obligation may consist of the obligation to deliver cash or another financial asset to another entity, or to exchange financial assets or financial liabilities with another entity. The condition is provided that the exchange must be potentially unfavorable for the entity itself.

A financial liability can also exist in the form of a contract that will or may be settled in the entity’s own equity instruments. IAS 32 identifies two sorts of contracts: derivative or derivative. First, a non-derivative for which the entity is or may be obliged to deliver a variable number of the entity’s own

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equity instruments. The obligation to deliver forms the opposite of the obligation to receive under a financial asset. A financial liability as a derivative equals the definition for a financial asset as a derivative. For a derivative, the exchange of a fixed number of equity instruments is not settled by cash or another financial asset. When this is the case an entity’s equity instruments do not include puttable equity instruments.

2.1.4 Equity instrument

Besides financial assets and financial liabilities the definition of a financial instrument also contains the category equity instrument. IAS 32 provides the following definition of an equity instrument:

Any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities. [IAS 32.11]

Thus an equity instrument is the residue or difference after deducting financial liabilities from financial assets. An equity instrument is characterized by the absence of a financial obligation, this is the main difference with a financial liability, Ernst & Young, (2009, P. 2240).

IAS 32 provides a few exceptions in which an instrument that meets the definition of a financial liability may be classified as an equity instrument. These exceptions however are not relevant for the topic of this thesis.

2.2 IAS 39 Financial Instruments: Recognition and Measurement

This standard covers the recognition of financial assets and financial liabilities and subsequent the measurement of those assets and liabilities. IAS 32 already set out the principles for what should be regarded a financial asset or a financial liability. IAS 39 uses this as an input for the accounting treatment of financial assets and liabilities with regard to recognition and measurement.

2.2.1 IAS 39 Financial instruments: Recognition

IAS 39 defines the categories for the recognition of financial assets and liabilities, each category with its own characteristics. Figure 2 (Bout et al. 2010) illustrates the recognition and subsequent measurement of financial assets and liabilities according to IAS 39. Financial liabilities are either recognized as Held for Trading or designated as Fair Value Option. The categories Held for Trading and Fair Value Option together form the category Fair Value Through Profit or Loss. Financial liabilities not recognized in this category are recognized as other financial liabilities. For financial assets there are three additional categories, Held-to-Maturity, Loans and Receivables and Available for Sale besides the Fair Value Through Profit or Loss category. With regard to derivatives IAS 39 distinct between derivatives held for trading and hedging derivatives, only the trading derivatives are recognized as held for trading.

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2.2.2 IAS 39 Financial Instruments: Categories

As depicted in Figure 2 (Bout et al. 2010) the recognition process leads to a categorization of the financial assets and liabilities. Each category has its own characteristics which I now briefly describe.

2.2.2.1 Fair Value Trough Profit or Loss

The fair value trough profit or loss category consist of two different categories, Held for Trading and Fair Value Option. IAS 39.9A distinct between three types of financial instruments that are to be recognized as held for trading. First, those financial instruments that are held for the purpose of selling or repurchasing in the short term. Second, those financial instruments for which a pattern of short term profit taking exists. Third, those financial instruments that meet the definition of a derivative but is not a hedging derivative.

Trading activities refer to the frequent buying and selling of financial assets, however derivatives may just be held for hedging or risk management purposes, Ernst & Young (2009, P. 2109).

[IAS 39.9] defines a derivative as a contract with three characteristics. First, its value changes in response to a change in value of a specified interest rate, financial instrument price, commodity price, foreign exchange rate, index of price rates, credit rating or credit index or another variable. In the case of a non-financial variable the variable must be a specific party to the contract. Second, a derivative should require no initial net investment or at least a net investment that is smaller than would be required for contracts that have a similar response to a change in market factors. Third, the derivative should be settled at a future date. Examples of derivatives include exchange rates contracts to hedge against

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changes in the value of foreign exchange rates, or interest swaps that neutralizes changes in interest rate.

The fair value option category is introduced by the IASB to enable financial institutions to match their asset and liability side of the balances sheet to minimize volatility in earnings. Thus a financial instrument that might be recognized in another category is designated as fair value option if designating as such results in more relevant information. This would be the case when an accounting mismatch could be reduced or by the ability to manage a group of assets and liabilities at fair value. To reduce an accounting mismatch an entity must carry assets and liabilities that are related to each other and on which gains and losses are recognized. For the application of the fair value option it does not matter whether the accounting mismatch may only affect the balance sheet and not the profit or loss account, Ernst & Young (2009, P. 2111). Ernst & Young (2009, P. 2112) explains that an entity is only allowed to apply the fair value option to part of a group of financial assets or liabilities if such partly application results in the most relevant information. Ernst Young (2009, P. 818) mentions two examples in which the fair value option can be applied. The fair value option category can be used as an alternative to use hedge accounting. In some cases the category is also used to prevent the decomposition of a financial instrument that contains an embedded derivative. However this comes at the cost of increased inflexibility, since the classification into the fair value category cannot be changed in a future period. My empirical research will show to what extent European banks use this category. Changes in the value of a financial instrument recognized as fair value through profit or loss are recorded in the income statement. These changes can be either positive or negative, resulting in gains or losses.

2.2.2.2 Held to Maturity

If an entity has the positive intention and the ability to hold non-derivative financial assets until maturity the assets are recognized as Held to Maturity, provided the entity does not recognize the financial asset in a different category. With this definition the IASB stresses the importance of the intention to hold the financial asset to maturity according to Ernst & Young (2009, P. 2117). A financial asset may not be classified as held to maturity if the entity has sold or reclassified a significant amount of the financial asset in the current or previous two fiscal years. This condition has a few exceptions which are described in [IAS 39.9.]

Financial assets that are sufficiently liquid can only be measured at amortized cost when the entity has the positive intention and ability to hold the investments to maturity, Ernst & Young (2009, P. 2122). Financial instruments recognized as held to maturity are measured at amortized cost. Amortized cost and the effective interest method used to estimate the amortized cost are presented in paragraph 2.3.2. Changes of a financial instrument recognized as held to maturity are the result of impairments and are recorded in the income statement as a loss.

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2.2.2.3 Loans and Receivables

Financial assets that are non-derivative and contain fixed or determinable payments that are not quoted in an active market are recognized as loans and receivables. Four exceptions exist to this general rule. The financial assets are not to be sold in the near term or recognized as fair value option or available for sale. If the entity may not recover all of the investment for another reason than credit deterioration the asset should be recognized as available for sale as well. An interest in a pool of assets can also not be recognized as loans and receivables. [IAS 39.9] Financial assets that are quoted in an active market can only be recognized as held to maturity.

Financial instruments recognized as loans and receivables are measured at amortized cost. Amortized cost and the effective interest method used to estimate the amortized cost are presented in paragraph 2.3.2. Changes of a financial instrument recognized as loans and receivables are the result of impairments and are recorded in the income statement as a loss.

2.2.2.4 Available for Sale

Financial assets may be recognized as available for sale provided they are non-derivative financial assets. The available for sale category also contains those financial assets that are not recognized as loans and receivables, held-to-maturity of fair value through profit or loss. [IAS 39.9] In practice the only type of asset that would qualify for classification as available for sale would otherwise be classified as loans and receivables, Ernst & & Young (2009, P. 2124).

Changes in financial assets recognized as available for sale are reflected in other comprehensive income, in a reserve for gains and losses on these assets. Upon the sale or maturity of a financial asset recognized as available for sale the amount of the reserve is transferred to the income statement. Positive values results in gains, negative values result in losses.

A financial asset recognized as available for sale mail be impaired during the holding period. The impaired amount is presented as a loss in the income statement for the year.

2.2.2.5 Hedging Derivatives

The concept of derivatives is defined earlier in paragraph 2.2.2.1 regarding fair value through profit or loss. Derivatives used for hedging are recognized separately and measured at fair value. IAS 39.9 defines a hedging instrument as either a designated derivative, non derivative financial asset or non-derivative financial liability whose fair value or cash flows are expected to offset changes in the fair value or cash flows of the hedged item. A hedged item is subsequently defined as an asset, liability, firm commitment, highly probable forecast transaction or net investment in a foreign operation that; exposes the entity to the risk of changes in fair value or future cash flows and is designated as being hedged.

Changes in the value of a financial instrument recognized as hedging derivatives are recorded in the income statement. These changes can be either positive or negative, resulting in gains or losses.

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2.2.2.6 Other Financial Liabilities

Financial liabilities that are not recognized as a hedging derivative or as fair value through profit or loss are recognized as other financial liabilities. The fair value through profit or loss category exists of financial instruments recognized as held for trading or designated as fair value option. These other financial liabilities are measured at amortized cost. [IAS 39.46]

2.2.3 IAS 39 Financial instruments: Measurement

The recognition of financial assets and liabilities in the diverse categories is the basis for the measurement of these assets and liabilities. From Figure 2 it follows that IAS 39 identifies three possibilities for two different accounting methods.8_{Financial instruments are either valued at fair value} or at amortized cost. Changes in the fair value of a financial instrument are not always treated equally. For financial assets recognized as available for sale the fair value changes are recorded in an equity reserves. In case the fair value change consists of a permanent loss, the change is presented as impairment in the profit and loss account. For financial assets and liabilities measured at fair value, but not recognized as available for sale, the changes in fair value are presented as an extra line item in the profit and loss account. In paragraph 2.3 the impairment procedure is described in more detail.

2.3 Accounting methods

Given the classification following IAS 32 and the recognition of IAS 39 a financial instrument can be measured at either fair value or historical cost. In this paragraph I introduce fair value accounting and historical cost accounting as presented in IAS 39. I start with fair value accounting and will then move on to introduce historical cost accounting.

2.3.1 Fair Value Accounting

Fair value is the attempt to use market consensus regarding the expected future cash flows in the valuation of financial instruments, Wikepedia (2010). As such it has been promoted by the IASB and the FASB in recent years. That is how fair value has generally become a much more prevalent valuation method for financial instruments, since its introduction 50 years ago. Fair value is currently defined as:

Fair value is the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arms length transaction. [IAS 39.9]

This definition applies to a normal transaction. An arms length transaction indicates that the partners in the transaction are on equal footing. Knowledgeable implicates that the parties involved in the transaction are capable of determining whether the amount transferred reflects the value of the asset or

8

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liability. The parties are willing in the sense that both parties agree on the transaction taking place, which is not the case in forced transactions. How the amount is estimated is described in paragraph 2.3.1.1.

2.3.1.1 Estimating the fair value

IAS 39 distinct between two situations for estimating the fair value, a situation with an active market and a situation in which the market for a financial instrument is not active. At initial recognition the IASB regards the transaction price the best evidence for fair value measurement [IAS 39 AG76]. After initial recognition the value is regularly re-estimated. In this case the best evidence for a fair value is a quoted price in an active market [IAS 39.48A]. In the application guidance to IAS 39 [AG69-AG82] the IASB formulates an approach for how the fair value should be estimated if such a transaction price is not available. In paragraph 2.3.1.3 I summarize the conclusions of the Expert Advisory Panel on how to measure financial instruments in markets that are no longer active.

The IASB stresses that fair values are estimated for an entity that is a going concern. Therefore fair value is not the amount that an entity would receive in a forced transaction. Instead the fair value reflects the credit quality of the financial instrument. The market for the fair valued financial instrument can be either active or non-active. IFRS 7: ‘Financial Instruments: Disclosures’ contains a fair value hierarchy that describes guidelines for the valuation of financial instruments. This hierarchy consists of three levels of which the first two refer to active markets and the third to neither an active market nor a recent market transaction [IAS 39 BC102]. In paragraph 2.4 the level hierarchy is presented in more detail. This section continues with a summary of the application guidance to IAS 39 on how to measure financial instruments in active or non-active markets.

In an active market the best evidence for fair value at initial recognition is the transaction price [IAS 39 AG64]. For subsequent measurement at fair value market price quotations are to be used, if present.9_In case such data is not available the most recent transaction price provides the best evidence, provided the economic situation has not changed significantly since that transaction took place, [IAS 39 AG72]. If conditions have changed, the fair value can be estimated by a reference to the price of similar financial instruments. If the market contains no observable prices for the entire financial instrument it may be measured by observable price quotations for its components, [IAS 39 AG72]. When rates rather than prices are quoted in the market, an entity can use these rates as input in a valuation technique to estimate the fair value.

Only in case the market is not active, a valuation technique should be used to estimate what the fair value would have been in a normal transaction in an active market, [IAS 39 AG74]. Using a valuation model, one can expect to form a reasonable estimate of fair value if two conditions are present. First, the valuation should incorporate all factors that market participants would consider. Second, the valuation

9_{Market observable inputs include for example quoted prices for similar assets, interest rates, yield curves, credit spreads and}

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model should be consistent with accepted economic methodologies for pricing financial instruments, [IAS 39 AG 75 and AG76].

When a model is used to estimate a fair value in this way the model should include inputs regarding recent market transactions. In IAS 39 a number of valuation techniques are mentioned including: recent arms length transactions, option pricing models, discounted cash flow analysis and, if available, reference to a current fair value of another instrument that is substantially the same.

The valuation technique most used in the market should be used to estimate the fair value of the financial instrument. In estimating the fair value an entity should include all relevant available information, incorporating all factors that market participants would consider. In order to ensure that the fair value estimate reflects the current market situation the model used for the valuation should be periodically calibrated. IAS 39 AG82 provides a list of parameters that can be used as input for the valuation technique.

2.3.1.2 Fair value measurement in the financial crisis

In the course of the financial crisis, the IASB published an exposure draft to IAS 39: Fair Value Measurement in which the definition of fair value has changed to the following:

Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly [i.e. not forced] transaction between market participants at the measurement date. [Exposure draft to IAS 39]

The new definition stresses the importance of a transaction at a certain date, as a more particular point in time. It is also clear about the situation and the circumstances in which the transaction takes places, as Bout et al (2010) note. Fair value is equal to the transaction price, which is more detailed than the description ‘an amount’ under the current definition. The transaction price needs to be established under normal market conditions in an orderly transaction. Therefore fair value is not in all circumstances equal to market value, EAP IASB (2008). In illiquid markets the fair value can be higher than the market value. Thus, according to the IASB, liquidity in the market is no prerequisite for the estimation of the fair value for a financial instrument. This definition provides a better guideline for how to measure a financial instrument when no market exists. In November 2009 the IASB published IFRS 9: Financial Instruments. That standard refers to the non-amended old definition of fair value as presented in IAS 39.9.

2.3.1.3 Estimating the fair value in markets that are no longer active

The IASB realized the difficulties of estimating the fair value in illiquid markets and installed the so called Expert Advisory Panel to publish a report on measuring and disclosing the fair value of financial

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instruments in markets that are no longer active. Though the report does not specify what should be regarded a non-active market, it does provide guidance on how to estimate fair value in such markets. The report stresses that the fair value should be based on all relevant market information available. The Expert Advisory Panel concludes that the current transaction price is, or remains, the best estimate for fair value even in non-active markets. If and only if it concerns forced, or involuntary transactions, the transaction price may not equal with the fair value. In order not to estimate the fair value too low in such cases the Expert Advisory Panel stresses that all relevant information should be used as input in the valuation process. According to Ernst & Young (2009, P. 2348) an active market has readily observable prices and regularly occurring transactions. The temporal disappearance does not directly imply that the active market has ceased to exist, this should be judged in the context of the circumstances.

The Expert Advisory Panel does not regard cash flow analysis an appropriate method for estimating fair value as it does not incorporate the increased risk and liquidity factors that the financial crisis imposed. In general, the Expert Advisory Panel emphasizes that when a valuation technique is used, the outcome should reflect the market inactivity and illiquidity. The expert advisory panel stresses that the models used for fair valuing financial instruments that are not traded in an active market, should be regularly updated and tested.

In using such a technique to estimate fair value the entity should judge the representativeness of this fair value. Therefore it may be the case that different financial institutions can report different values, for similar instruments. This increases the need for quality disclosure, containing the valuation method and the fair value outcomes from different models, according to the Expert Advisory Panel (2008). The Expert Advisory Panel report (2008) provides best practices for such disclosures.

2.3.1.4 Fair value gains and losses

The fair value of financial instrument may change during the holding period resulting in gains and losses. IAS 39.55 sets out how these gains and losses are treated, depending on the category in which they arise. Fair value changes for financial instruments classified as fair value through profit or loss shall be recognized in the profit or loss account.

The fair value gains and losses for financial assets classified as available for sale are treated differently. The fair value changes are recognized in other comprehensive until the financial asset is derecognized. Upon derecognition of the financial assets the gains and losses of this instrument are transferred from other comprehensive income to the profit or loss account. Fair value changes as a result from impairment or foreign exchanges are however directly recognized in the profit or loss account rather than in a reserve in other comprehensive income. The impairment procedure for financial assets recognized as available for sale is described in paragraph 2.3.2.1.10

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2.3.2 Historical Cost Accounting

The fair value approach to accounting tries to capture the market value whereas under historical cost there is no direct reference to the (current) market value. Historical cost accounting has long been the only valuation method for all assets and liabilities. Fair value was introduced only 50 years ago but historical cost accounting still remained the number one valuation method. It was only when both the IASB and the FASB actively promoted fair value accounting that fair value became more important for the valuation of financial instruments. Historical cost accounting however is still the accounting method most used for the valuation of financial instruments as this thesis shows.

In IAS 39 Financial Instruments: Classification and Measurement, the IASB defined Historical Cost Accounting as:

The amortized cost of a financial asset or financial liability is the amount at which the financial asset or financial liability is measured at initial recognition minus principal repayments, plus or minus the cumulative amortization using the effective interest method of any difference between that initial amount and the maturity amount, and minus any reduction (directly or through the use of an allowance account) for impairment or uncollectibility. [IAS 39.9]

Financial instruments are thus recorded at the original amount at the moment of inception. The carrying amount is calculated using the effective interest method, under which the interest is allocated over the relevant period. In estimating the effective interest the entity estimates all cash flows except the cash flows resulting from credit losses. The book value of the financial instrument is then equal to the present value of future cash flows, discounted with the historical yield at the time of the issue. In some cases the amortized cost will equal the fair value, this may be the case for instance for cash and cash equivalents, accounts receivable and accounts payable. Gains and losses are realized when the asset is sold or the liability is settled and these have a direct impact on earnings. This in contrast to fair valuing where gains and losses are presented in the profit or loss account or are recognized in other comprehensive income when they occur. Gains and losses for financial instruments at fair value through profit or loss are also recognized in the income statement when they occur but in contrast to historical cost accounting this may well be before the financial instrument is sold or settled.

2.3.2.1 Impairment under IAS 39

A financial instrument may be impaired during the holding period. In IAS 39 the impairment procedure is described and distinction is made between impairment for financial assets measured at amortized cost and those recognized as available for sale and thus measured at fair value, [IAS 39.58]. IAS 39.58 also describes an impairment procedure for financial assets carried at cost but I will not present the impairment treatment for such assets in this thesis.

Marking-to-Market or Marking-over-the-Market? The Influence of Measurement of Financial Instruments at European banks on Procyclicality

Marking-to-Market or Marking-over-the-Market?

The Influence of Measurement of Financial Instruments at European banks on Procyclicality

Henk-Jan Nanninga

Marking-to-Market or Marking-over-the-Market?

Preface

Contents

Chapter 1 – Introduction

1.1 Relevance

1.2 Research Questions

1.3 Conceptual Framework

1.4 Goal and Scope of this thesis

1.5 Structure

Chapter 2 – Institutional Framework

2.1 IAS 32 Financial instruments: Presentation

2.2 IAS 39 Financial Instruments: Recognition and Measurement

2.3 Accounting methods