IASB/FASB convergence suffers its own impairment loss
27 September 2012
So, like many in Europe I headed off on summer holidays thinking the Boards (IASB and FASB) have been working harmoniously on their financial instruments project and that we might yet have convergence, only to come back and find out that the FASB has decided to abandon the jointly deliberated model and pursue their own model for impairment of financial assets (see our ‘straight away’ guidance).
The current, ‘incurred loss’ impairment model for financial assets was criticised during the global financial crisis. Indeed, one of the key messages that the Boards received from the G20 was that a converged impairment model is critical to responding to the global financial crisis. The issue with the current model is that impairment losses (and resulting write-downs in the reported value of financial assets) can only be recognised when there is evidence that they exist. Companies are not allowed to consider the effects of losses expected in future. There is a view that earlier recognition of loan losses may have reduced the cyclical moves in the recent crisis. So after spending almost two years working together on an expected loss model, it is disappointing that the FASB has decided to go in its own direction – and so soon after the Boards finished debating the key technical principles of what we thought was a converged model, the ‘three-bucket model’.
Throughout the development of the joint model, the staff of both Boards held outreach sessions with various parties. The FASB in particular heard significant negative feedback from US constituents: that further clarifications of the model were necessary; but also a broader concern about the model’s operability and whether comparability may actually be reduced as a result, as it was noted that defining the concepts would be difficult.
The FASB concluded that it should develop a simpler model based on booking a full provision for lifetime losses on loans as they are originated.
While the IASB’s outreach was more positive, how operational its model proves to be will depend on the clarity of the trigger point that moves a loan from the first bucket to one of the others.
The FASB model may be simpler from an operational perspective, but one has to question the conceptual merits of recognising impairment losses when an entity originates or purchases a financial asset at fair value, as a day 1 loss does not reflect the economics of a market-based transaction. The IASB model, while also not conceptually pure, is at least trying to acknowledge that credit risk is priced into the interest rate on debt instruments and the income to cover expected losses is earned over the life of the loans.
Bucket 1 in the current IASB model is a compromise, made with the aim of achieving convergence. Now that convergence has failed, the IASB must have been tempted to go back to a variant of its original proposal, which essentially required the credit risk element of interest pricing to be identified and set aside as a future loss reserve.
However, the industry saw the original model as too complex, and there is a pressing demand to get the new model finalised. The IASB has said it will press on with the three-bucket model.
It is a great pity that we won’t have a converged model. Like many, I saw this as one of the most important areas to achieve convergence given the intense focus on bank capital today. However, we can’t wait much longer for an expected loss model.
As ever, I welcome your thoughts on this issue.