IFRS & Financial Institutions

The aim of this final article is to explore the impact of IFRSs on a key sector of the economy – financial institutions. It is critical to form a perspective for two reasons; firstly such institutions play a critical role in the economy and have recently been buffeted globally by a financial crisis which has lead to significant changes in the accounting and secondly the degree of impact of adoption of IFRSs is higher as compared to other industries. It is also here that the controversial spectre of market-to-market accounting or MTM has its greatest impact. The past years have seen dramatic changes in the financial institution landscape globally. As a consequence of the same, the accounting under IFRS for such institutions is also in the process of undergoing dramatic changes.

The IASB (International Accounting Standards Board), the body which issues IFRSs, is overhauling the entire accounting literature for financial instruments and plans to issue completely revised accounting guidelines for the area. Consequently, what one has to realise is that the accounting that will ultimately be adopted by Indian banks and other financial institutions is currently a work in progress that will evolve over the next year rather than a body of readymade literature that one can review. It is also primarily for this reason that the adoption date for IFRSs for financial institutions in India is 2013 and not 2011.

So what does IFRS try and achieve when we consider the accounting for financial institutions? In a nutshell what it tries to do is reflect in the financial statements the risks facing financial institutions and the methods and measures that such institutions have in place to mitigate and manage such risks. It also tries to capture the efficiency and efficacy of such risk management processes and procedures. Consequently, the business models that a financial institution employs will drive the accounting under IFRSs.

IFRS divides the business models employed by financial institutions generally in two categories: the banking book and the trading book. In case of a banking book an institution aims to generate profits through its lending activities. The aim is to generate positive returns by achieving a rate of lending that provides a positive margin over its financing or borrowing costs. Or in banking terminology, the aim of the business model is to maximise its NIM or net interest margin. [PAGE BREAK]

Also, the risks undertaken are primarily interest rate risk and credit risk and not market risk arising from movements in fair values of its loan book. Under IFRS the accounting will reflect the business model being employed whereby the accounting will focus on capturing the impact of movements in interest rates and credit risk on the reported performance rather than fair value movements of the underlying loan book.

The disclosures under IFRS will capture how well the business manages its interest rate risk and credit risk as compared to its peers and other members also employing such a business model. On the other hand if the business model is that of a trading book then the aim is to earn returns from market movements in the value of assets and liabilities or through trading activities.

Under such a business model, the key economic driver is movements in fair value of investments as the business aims to maximise returns arising from market movements rather than income from interest or dividend streams. Consequently, the risks in such a business model will primarily be market risk with exposures arising from movements in markets. In case of such business models the accounting will, as before, aim to capture the gains or losses arising from market movements or through fair value measurement of assets and liabilities.

The disclosures on the other hand will focus on elements of risk management like Value at Risk or other measures used by the financial institution to manage such risks. The critical thing to note in the above framework is that a single institution can have different business models and IFRS acknowledges and accommodates this in its guidance. What IFRS tries to achieve is harmonisation between the accounting and the key economic drivers that are represented in the business models employed by financial institutions.

The goal is to try and capture the elusive ‘economic reality’ of transactions undertaken in an ever-growing and complex business scenario of financial services.