Reviewing(the(modeling(for( IFRS9(to(add(value(for(regulators,( - - PowerPoint PPT Presentation

Reviewing(the(modeling(for( IFRS9(to(add(value(for(regulators,( banks(and(their(shareholders

Brandon(Davies Board(Director

Board(Directors(Personal(Risk

• The(time(has(come(to(implement(IFRS9.
• I(propose(to(take(a(“boards(eye”(view(of(this(process.
• The(board(signs(off(on(the(accuracy(of(the(companies(

accounts(for(which(they(are(legally(responsible.

• The(board(is(responsible(for(steering(market(

expectations(with(respect(to(a(companies(financial( performance(through(earnings(announcements( (usually(quarterly).

• For(banks(in(particular,(because(provisions(have(such(a(

large(effect(on(earnings(and(potentially(capital,(the( accuracy(of(IFRS9(based(provisions(represent(an( enormous(potential(liability.(((

Board(Directors(Personal(Risk

• Regarding(board(directors(potential(jeopardy,(the(

BoE(states(that:

• “(The(new(legislation(introduces(powers(that(enable(us(

to(impose(sanctions(on(senior(managers(at(a(bank(that( fails(to(keep(within(the(rules.(We(will(be(able(to(take( action(against(the(senior(manager(responsible(for(the( area(where(a(failure(occurred(if(he(or(she(cannot( demonstrate(that(they(took(reasonable(steps(to(avoid(or( stop(the(problem.” and

• “Criminal(prosecutions(can(be(bought(against(senior(

managers,(if(their(companies(fail,(and(their(conduct(fell( significantly(below(what(could(be(“reasonably(expected” (“Irresponsible(conduct(carries(consequences(in(British( finance”(Andrew(Bailey,(Deputy(Governor(for(Prudential( Regulation(at(the(BoE(– FT(23/2/2015)

Board(Directors(Personal(Risk

• They(are(required(to(give(a(“Longer(Term(Viability(Statement”.
• Confirming(that:

! “Directors*should*state*whether,*taking*account*of*the*company’s* current*position*and*principal*risks,*they*have*a*reasonable* expectation*that*the*company*will*be*able*to*continue*in*

• peration*and*meets*its*liabilities*as*they*fall*due*over*the*period*
• f*their*assessment,*drawing*attention*to*any*qualifications*or*

assumptions*as*necessary*(Code*Provision*C.2.2)

• Bank(boards(will(need(to(consider(very(carefully(what(period(
• f(assessment(they(wish(to(choose(when(making(their(long(

term(viability(statement.(

• Some(77%(of(UK(companies(have(put(this(statement(along(

with(the(”Robust(Assessment(of(Principal(Risks”(disclosure( into(the(Strategic(Report(to(gain(the(“safe(harbour”(cover.(

Board(Directors(Personal(Risk

• When(we(look(at(financial(reporting(for(UK(companies(the(UK(Companies(

Act(from(October(2014(requires(UK(companies(– whether(listed(or( unlisted(– to(prepare(a(Strategic(Report(in(place(of(the(current(business(

• review. The(Financial(Reporting(Council(guidance(on(the(Strategic(Report(

states(that(one(objective(of(the(report(is:

! “to*provide*information*on*the*entity*and*insight*into*its*main*objectives*and*strategies,* and*the*principal*risks*it*faces”(another(is(“to*compliment,*supplement*and*provide* context*for*the*related*financial*statements”.((UK(Companies(Act(2006,(amendment( 2014)(

• Bank(boards(are(required(by(the(PRA(to(have(a(strategy(document(outlining(the(

companies(business(model(and(strategic(plan.(Bank(boards(will(need(to(ensure( alignment(between(the(Companies(Act(requirement(and(PRA/(FCA(requirements( which(should(not(differ(in(any(material(respects.

• Section(463(of(the(Companies(Act(provides(a(“safe(harbor”(for(disclosures(in(the(

Strategic(Report(unless(deliberately(untrue(or(misleading(or(is(recklessly(made((or( deliberately(conceals(a(material(fact.(

• Could(IFRS(provisions(be(put(here?

Board(Directors(Personal(Risk

• The(importance(of(the(Strategic(Report(is(further(attested(to(by(its(link(to(

the(requirement(by(boards(to(make(a(statement(to(the(effect(that(the( report(and(accounts(are(“Fair,(Balanced(and(Understandable”.

• Their(obligation(is(to(confirm(that:

! “The*board*confirms*that*the*annual*report*and*accounts,*taken*as*a*whole,*is*fair,* balanced*and*understandable*and*provides*the*information*necessary*for*shareholders* to*assess*the*performance,*strategy*and*business*model*of*the*company.”*(UK*Corporate* Governance*Code*2013)

• Bank(boards(will(especially(need(to(consider(how(the(direct(link(of(the(accounts(to(

the(strategy(and(business(model(of(the(bank(is(to(be(achieved.(One(facet(of(such( reporting(would(be(to(look(at(the(segmental(reporting(in(the(accounts.(

• There(is(also(a(need(to(ensure(there(is(no(discrepancy(between(the(business(as(

described(in(the(narrative(at(the(front(of(the(report(and(accounts(and(the( performance(as(described(by(the(financial(accounts(at(the(back(of(the(report(and( accounts.(

• What(happens(if(the(IFRS9(credit(provisions(prove(not(to(be(accurate?(

What(Board(Directors(Need

Assurance Defensibility

This(is(what(stops(you(going(over(the(edge

Start(with(the(obvious

• How(should(a(CRO(&(CFO(guide(the(board(to(obtain(its(

backing(for(the(IFRS9(expected(loss(provisions(and(thus(the( banks(earnings?

• Start(with(the(obvious.

“The(future(is(not(unknown(it is(unknowable”(J.M.(Keynes(f a( treatise(on(probability.

• So(any(projection(of(a(number(into(the(future(is(

probabilistic(i.e.(it(consists(of(two(parts(a(number(and(an( associated(probability(of(its(occurrence.((

Start(with(the(obvious

Future(numbers(are(not(congruent(with(accounting(numbers( that(have(traditionally(been(historic(and(therefore(deterministic

The(Passed Deterministic(Numbers The(Future Probabilistic(Numbers

Start(with(the(Obvious

• Thus(whilst(the(concept(of(an(expected(credit(loss(is(

conceptually(alluring(and(in(hindsight(relatively(easy(to( calibrate,(projecting(an(expected(credit(loss(into(the(future( is(more(problematic.

• Future(credit(losses(will(be(Dynamic(and(Conditional.(They(

change(and(will(be(affected(by(the(general(economic( conditions(of(the(relevant(economy.(

Move(on(to(the(Accounting(Standard

• IFRS9(breaks(down(into(two(main(parts;
• An(operational(model(that(requires(a(great(

deal(of(data(gathering(and(analytical(capability( to(establish(the(allocation(of(loans(to(three( stages:f

Source(– GENPACT(Point(of(View

Move(on(to(the(Economic(Model

• Whilst(the(operational(model(is(expensive(and(

may(require(major(changes(to(credit(processes( and(procedures(it(is(relatively(simple(to( understand.(

• The(relationship(between(the(losses(on(various(

portfolios(and(their(relationship(to(major( economic(variables((output,(employment,( interest(rates,(wage(inflation(etc.)(is(vital(to( forecasting(expected(loss.

• Macro(Economic(Models(are,(however,(not(easily(

understood(and(their(projections(are(not(reliable.

Projections

Sources: Thomson Datastream, ECB

Euro-zone CPI Inflation & ECB Forecasts (% y/y) (2012 – 2018)

• 0.5

0.0 0.5 1.0 1.5 2.0 2.5 3.0

• 0.5

0.0 0.5 1.0 1.5 2.0 2.5 3.0 2012 2013 2014 2015 2016 2017 2018 Current forecast Past forecasts Actual ECB's target of near 2%

Sources: Various

Loss Gain

Estimates of Impact of Brexit on UK Economy (As a % of GDP)

• 12
• 8
• 4

4 8 12 LSE/CEP (2014) HM Treasury (2016) CBI (2013) Oxford Economics (2016) CBI/PwC (2016) CEP/LSE (2016) Bertelsmann Stiftung (2015) IEA (2015) NIESR (2004) Open Europe (2015) Institute of Directors (2000) Minford & Mahambre (2005) Civitas (2004) Patrick Minford (2016) Tim Congdon/UKIP (2012)

Markets(are(no(better

Economists(Know(This

So(The(Board(Should(Know(This

Macro(Models(Do(have(Benefits

They(produce(probability(distributions(and(have(credibility( (BoE(Quarterly)

Macro(Models(Do(have(Benefits

• IFRS9(requires(banks((and(other(companies)(to(choose(

“probability(weighted”(outturns(from(their(IFRS9( scenarios(to(calculate(their(expected(losses.

• Independent(scenarios(can(at(best(only(have(highly(

subjective(probabilities(associated(with(them.(They(are( little(more(than(guesswork.

• But(scenarios(that(can(be(derived(from,(and(are(

congruent(with,(the(paths(of(interest(rates,(output(and( employment(resulting(from(a(macro(model(are( defensible.

• So(which(would(you(prefer(if(you(wanted(ASSURANCE?
• Which(will(be(more(convincing(to(a(judge(and(jury?

Assurance(&(Defensibility

• Assurance(is(what(board(directors(seek(from(their(

executives.

• But(increasingly(under(pressure(from(activist(

shareholders(and(the(SMCR(they(also(seek(the( defensible.(

• What(is(the(more(defensible(a(weighted(average(of(a(

number(of(scenarios(to(which(either(the(executive(or( the(board((or(both)(have(ascribed(their(own( probabilities(OR

• The(weighted(average(of(the(outputs(of(the(BoE(

Model?

• If(you(were(giving(assurance,(which(would(you(choose?

The(BoE(/(NIESR(Model

• Finding(a(source(of(macro(economic(models(that(can(

provide(the(required(outputs(is(not(as(difficult(as(you(might( imagine.

• Indeed(the(dominant(model(in(the(UK(is(known(as(a(

Dynamic(Stochastic(General(Equilibrium((DGSE)(Model(and( was(developed(by(the(National(Institute(for(Economic(and( Social(Research((NIESR).(It(is(widely(used(by(the(UK( Treasury,(the(BoE(and(many(economic(institutes.

• If(you(need(similar(models(for(other(economies(the(IMF(is(

an(excellent(source.

• Potential(sources(of(outputs((scenarios)(based(largely(on(

their(own(versions(of(this(model(are(economic(analytical( companies(such(as(Oxford(Economics,(Capital(Economics,( Lombard(Street(Research(etc.

The(DSGE(Model

• If(you(want(to(run(your(own(version(the(Adam(Smith(

Foundation(helped(me,(and(if(you(want(assurance(on( such(a(model(any(of(the(above(or(possibly(the(Systemic( Research(Centre(at(the(London(School(of(Economics( could(be(very(helpful.

• The(DSGE(model(itself(has(plenty(of(room(for(variety(in(

its(outcomes(and(the(PRA(appears(to(want(banks(to( show(such(variety.

• But(there(is(very(real(danger(in(pursuing(such(a(route(if(

it(leads(you(to(be(“wrong(and(alone”.

• Assurance(and(Defensibility(are(constraints(on(how(far(

you(should(be(from(the(“official(view”(of(the(economy.

DSGE(f Current(state(of(mainstream

• Three(equation(model,(demand(function,(supply(

function,(Taylor(Rule(central(bank(reaction( function((Time(Consistent).

• DSGE(=(real(business(cycle(+(price/wage(frictions(

(no(demand(for(money(function)((+(interest(rates( leads(directly(to(inflation(therefore(no(financial( friction.

• No(default,(no(banks,(no(credit,(no(risk(premia.
• If(no(default(everyone's(IOU(is(as(good(as(a(bank(

note.

Taylor(rule(is(a(reduced(form(approximation(of(the( responsiveness(of(the(nominal(interest(rate,(as(set(by(the( central(bank,(to(changes(in(inflation,(output,(or(other( economic(conditions.

Policy(Analysis(Using(DSGE(Models:(An(Introduction,(Argia M.(Sbordone, Andrea(Tambalotti,(Krishna(Rao,(and(Kieran(Walsh

The(DSGE(Model

DSGE(f Current(state(of(mainstream

• No(intermediary(monetary(side(of(the(

economy,(no(direct(relationship(between(bank( lending(and(housing(finance,(no(liquidity( constraints(on(households.

• Leads(to(emphasis(on(central(bank(using(

interest(rates(to(signal(and(affect(future( expectations(of(inflation.(

DSGE(f Policy(Disconnect(

• QE1(/(TARP(worked(in(spite(of(models,(people(

horded(liquidity(&(risk(premier(rose,(liquidity( hoarded.(QE1(/(TARP(provided(a(flood(of(liquidity( and(this(freed(up(bank(liquidity(and(credit.

• Currently(assumed(QE1(/(TARP(worked(by(

signaling.((((QE2,(3(&(4(satiated(all(need(for( liquidity(but(rise(in(monetary(base(stopped( affecting(broad(money.

• Reserve(base(of(US(commercial(banks(rose(2009(f

14(one(hundred(fold!(Where(did(the(unlimited( inflation(go!(

DSGE(f Policy(Disconnect(

• Commercial(bank(reserves(became(interest(bearing(

and(therefore(an(asset(class.

• The(rate(on(reserves(is(the(key(interest(rate.(
• What(constrains(commercial(bank(lending(=(capital(

requirements(and(profitability(of(bank(assets.

• But(note(reduced(gearing(ratios(by(banks(do(not(much(

affect(their(need(for(net(interest(margin.(

• But(transitional(problems(huge,(capital(raising(dilutes(

equity(holders(and(pressure(on(markets(caused( commercial(banks(to(reduce(lending.

• US(TARP(in(particular(worked(quickly,(ECB(cold(turkey(

will(not.

Should(we(seek(other(ideas?

• William(White,(chairman(of(the(Economic(and(

Development(Review(Committee(at(the(OECD( in(Paris,(has(argued(that(“the(fundamental( analytical(mistake(has(been(to(model(the( economy(as(an(understandable(and( controllable(machine(rather(than(as(a( complex,(adaptive(system,”.

• The(SRC(at(the(LSE(is(at(the(forefront(of(

developing(such(models.

System(Dynamics(and(the(SRC

System(Dynamics(and(the(SRC

Monetarism

• Monetary(Economists(such(as(Prof.(Tim(

Congdon at(the(International(Institute(of( Monetary(Research(at(Buckingham(University( are(also(likely(to(have(different(views(on(the( evolution(of(the(economy.(

• Monetary(Analysis(tends(to(have(a(better(

explanation(of(the(post(2008(period(so(should( not(in(my(view(be(dismissed.(

Monetarism

M3(is(“broad(money”(primarily(commercial(bank(deposits

Conclusion

• Set(up(a(communication(process(with(your(board.
• It(should(cover(the(following:
• A(recognition(and(explanation(of(the(risks(the(board(runs(in(using(

expected(credit(loss(provisioning(in(the(accounts.

• An(explanation(of(how(to(mitigate(these(risks.
• A(explanation(to(the(board(of(the(technical(issues(involved(in(

projecting(the(macro(economy(and(developing(defensible(scenarios.

• An(agreement(as(to(the(economic(consultants(to(be(used(for(

developing(your(economic(scenarios(or(validating(your(own(model.

• An(agreement(as(to(whether(the(board(should(be(made(aware(of(

alternative(views.

• A(plan(for(how(the(above(is(to(be(agreed(with(your(auditors(and(

legal(advisors.

• A(plan(for(how(the(above(is(to(be(disclosed(to(shareholders.