The Basel Committee on Banking Supervision, an influential group of international banking regulators, has released a set of guiding principles to help the International Accounting Standards Board set new standards for financial instruments to deal with the aftermath of the financial crisis.

Nout Wellink

The principles relate to the replacement of IAS 39, the standard for financial instruments, which the IASB has been revising in response to the crisis. One of the key recommendations advises against extending fair value accounting to loans, as the U.S. Financial Accounting Standards Board has recently proposed.

“The new two-category approach for financial instruments should not result in an expansion of fair value accounting, in particular through profit and loss for institutions involved in credit intermediation,” said the Basel Committee paper. “For example, lending instruments, including loans, should not end up in the fair value category.”

The committee also recommended that the proposals should enhance the quality of information available about firms’ risk profiles, risk management practices and related gains or losses by enhancing both the accounting and disclosure requirements. Other recommendations stress that the new standard for financial instruments should allow banking transactions to be portrayed in “a robust and consistent manner in line with their economic substance. There should be a strong overlay reflecting the entity’s underlying business model as adopted by the board of directors and senior management, consistent with the entity’s documented risk management strategy and its practices, while considering the characteristics of the instruments.”

The committee also urged the IASB to avoid undue complexity, limit the use of options and the need for interpretations, be practical, avoid arbitrary rules, and incorporate “significantly simplified” hedge accounting rules that reflect the business model of the reporting unit.

The committee also recommended that the new standard for financial instruments should reflect the need for earlier recognition of loan losses to ensure robust provisions and recognize that fair value is not effective when markets become dislocated or are illiquid. The committee also wants the IASB to permit reclassifications from the fair value to the amortized cost category, “which should be allowed in rare circumstances following the occurrence of events having clearly led to a change in the business model,” and promote a level playing field across jurisdictions.

To address concerns about procyclicality, the committee also recommended that the new standards should provide for valuation adjustments to avoid a misstatement of both the initial and subsequent profit and loss recognition when there is significant valuation uncertainty. Loan loss provisions should also be robust and based on “sound methodologies that reflect expected credit losses in the banks’ existing loan portfolio over the life of the portfolio.”

“In developing the high-level principles, the Basel Committee closely examined the lessons learned from the financial crisis,” said Basel Committee chairman Nout Wellink, who is also president of the Netherlands Bank. “One of those lessons is that any new accounting rules must be consistent with sound practices in risk management and enhance transparency to help supervisors, banks, investors and other stakeholders achieve their respective objectives.”

The set of guiding principles come in response to the recommendations made by the G20 leaders at their April 2009 summit to strengthen financial supervision and regulation.