Purpose - This paper aims at addressing the relevance and importance of IFRS and Basel norms in the global economy. The effect of IFRS on the net income and the balance sheet of the company have been discussed. We have also tried to determine the relationship between Capital Adequacy ratio (CAR) and different banking parameters, as required under Basel disclosures.
Design/methodology/approach - The difference in accounting treatment under IFRS and current US GAAP have been analyzed to consider the impact of IFRS on the profitability of corporate. Basel I and Basel II CARs were regressed on relevant financial parameters like Investment deposit ratio (IDR), Credit deposit ratio (CDR) and net profit of 84 Indian banks. Besides, capital ratios of 104 international banks under IMF were compared against the expected minimum Basel III CAR requirement.
Findings - On an average, IFRS requirement of fair value estimation increases earnings and liabilities, while decreasing equity for the corporate. Besides, since the compensation of top management is usually tied to net income of the organization, IFRS implementation leads to re-design of the compensation package. It was also found that while CDR & IDR strongly influence CAR for public sector banks, net income plays a dominant role in case of private & foreign banks,
Research limitations/implications - The impact of only 3 parameters (IDR, CDR, net profit) have been considered on the CAR under Basel norms. Besides, since most countries have just adopted IFRS, the long term impact can't be generalized.
Practical implications - Banks can keep an optimum CAR by maintaining a balance between their CDR and IDR. Countries opposing Basel II disclosures should realize that there won't be any effect on their GDP growth rate over the long run. Similarly, companies should not find difficult adopting IFRS for harmonizing accounting between countries.
Originality/value - This paper presents one of the few combined studies on the two most dynamic upcoming banking and accounting standards.
Keywords - IFRS, Basel, CAR, GAAP, CDR, IDR, net profit, economy
Paper Type - Research Paper
Abstract- In the late 1980s banks started to become increasingly international in their operations. The Bank for International Settlements (BIS) established a framework that prescribed bank's minimum level of capital on the riskiness of the bank's assets. These were called Basel I norms.
IFRS is an official reporting standard. With globalization, companies or investors doing business across several countries would need to understand each nation's accounting principles. IFRS aims to harmonize accounting standards between countries, thus ultimately making it easier to conduct business internationally, as well as raise funds in global capital markets.
INTRODUCTION
IFRS and Basel norms complement as well as supplement each other in several ways. While Basel II disclosures are more forward-looking, IFRS disclosures assess the current financial position of an enterprise. Both require corporate to disclose information on their capital, their risk exposure, and risk management. This study tries to ascertain the strengths and weaknesses of Basel norms and IFRS with respect to the global economy.
BACKGROUND AND LITERATURE
Basel Norms
Each asset on a bank's balance sheet got a weighting between 0% and 100% for their riskiness. Under Basel I norms, banks were required to hold at least 4% of risk weighted assets (RWA) as tier 1 capital (shareholders funds and preference shares), and total capital of at least 8%.
As a result of regulatory capital arbitrage, Basel II was introduced that managed to take both operational and credit risk into account.
Capital adequacy is calculated as the ratio of the capital to the risk-weighted assets. Basel I defined a Tier I and a Tier II (debt instruments and other subordinated debts) form of capital. Tier II capital is easier to obtain, and more risky, and that is why minimum levels of total as well as Tier I capital are provided.
The mandatory capital requirement did have an impact on bank behaviour as it forced them to hold higher capital ratios than it otherwise would have been the case. Hall (1993) presents evidence that from 1990 to 1992 American banks have reduced their loans by approximately $150 billion, and argues that it was largely due to the introduction of the new risk-based capital guidelines. Ergungor (2003) noted that the dynamic development of loan securitization coincided with the imposition of new capital requirements and regulations limiting asset growth.
Basel III
The paper discussing impacts of BASEL norms on developing economies (Griffith-Jones & Persaud) suggests strong reservations against the BASEL II norms and considers them as quite complex and against the interests of the developing economies.
Basel norms cause a pro-cyclical effect in bank lending (Repullo & Suarez, 2009). Pro-cyclicality is a phenomenon where business cycles get exacerbated rather than easing out. During a downturn, the quality of loans goes down, increasing the risk for a bank. Now, it needs more capital to cover this risk, but the capital is more expensive now, and hence it leads to a further credit crunch. Under Basel III, credit ratings will also amplify the pro-cyclicality problem, as ratings go down in a downturn.
Another paper (Elliott, 2010) discusses the merits and demerits of BASEL III. The author believes in giving away some economic growth for the sake of avoiding another such crisis.
The proposed changes under Basel III are higher capital ratios, use of a leverage ratio, elimination of subordinated debt and hybrid capital (Resti & Sironi, 2010), new liquidity requirements, counterâ€cyclical capital requirements, elimination of goodwill and deferred tax assets.
IFRS
IFRS has recently been adopted by over 110 countries around the world. The number's expected to go up to 150 by 2012 end. While India, Canada, and Japan will adopt IFRS in 2011, others like Mexico would adopt it by 2012.
IFRS is principles-based while U.S. GAAP is more rules-based. A principles-based system focuses on presenting the business reality of business transactions. Therefore, IFRS requires more disclosures than many other standards. The standard proposes new names to the existing financial statements, as stated below (Benzacar, 2009).
Each statement would be divided into smaller categories- business activities, financing activities, income taxes and discontinued operations.
A number of research studies have been conducted to examine the impact of IFRS. Barth et al. (2008) investigated whether application of IAS in 21 countries between 1994 and 2003 was associated with higher accounting quality. Jeanjean and Stolowy (2008) observed that the occurrence of earnings management did not decline in Australia and the UK, and in fact increased in France, after the mandatory introduction of IFRS standards. Using a broad sample from 21 countries, Ahmed et al. (2009) found that in the post-adoption period, the degree of income smoothing increased and accrual conservatism decreased for IFRS firms relative to benchmark firms.
Under IFRS, Assets and liabilities acquired will be reported at 100 per cent of their fair value, even if less than 100 per cent of the business is acquired, acquisition costs will be expensed and impairment conditions might be reversed. These changes would also make net income very volatile (Benzacar, IFRS- The Next Accounting Revolution, 2008)
Under IFRS reporting, it may be necessary to alter compensation plans based on profits, as net income will change. The calculation of financial ratios, important for bankers in lending decisions and debt covenants, stock analysts, and portfolio managers would change.
Deutsche bank followed US GAAP until December 31 2006, but was required to conform to IFRS that was endorsed by the European Union. They also prepared a "Transition report" in order to show the differences between the two standards. In this section, we look at these differences. [1] These can vary depending on the nature of financial statement. The executive summary is shown in the Appendix 5.
Shareholders' equity went down by €142 million under IFRS, mainly due to different classifications and recognition of expenses which proves hypothesis 2
Net income increased by €84 million, which proves hypothesis 1
IFRS allowed consolidation increased the total assets
IFRS improves the functioning of global markets and would provide much better information. The method also overcomes the weaknesses of the rules-based standards. Rules force a one-dimensional treatment of transactions, take time to change, and need regular amendments. Also there is a general belief that IFRS focuses strongly on corporate governance and business ethics (Austin & Tschakert, 2009).
BASEL
Basel Committee found that the stronger capital and liquidity requirements would only have a modest impact on growth. If phased over 4 years, the changes would cause a 0.20% decline in GDP for each 1% increase in the capital adequacy ratio. On an average, this filters out to reduction of 0.04 percentage points in annual growth rate over the period. (Basel Committee on Banking Supervision, August 2010)
Similarly, a 25% increase in liquid assets would decrease output by just about 0.1%. A lesser period for phasing would increase the impacts but it was found the economy returned to its normal level after this period. (Macroeconomic Assessment Group, August 2010)
Impact of a 1 percentage point increase in the target capital ratio implemented over four years
Source: BIS Study
The authors state that on an average, economic crises occur every 25 years, with small recessionary trends in between. After studying the impact of all the slowdowns in the last 30 years, they found the impact of these on the GDP. Overall, the median cumulative output loss across all the studies comes out as 63% of pre-crisis output, while the average loss exceeds 100%. Clearly, the impact on output is huge.
Output around Banking Crises
Source: IMF (2009)
As can be seen there is a clear fall in the GDP for at least 2 years after the crisis. In some cases like the 1981 crisis in Mexico, the economy takes years to recover back to its original level.
By following stricter guidelines, these effects can be reduced. The studies find that a 1% reduction in the probability of crises generates benefits up to 0.2% of GDP per year. For crises with long-lasting effects, the gains can increase to between 0.6% and 1.6% of GDP per year.
Capital and liquidity requirements also reduce the amplitude of normal business cycles. For studying this aspect, the impact of technology shocks, defined as sudden changes in output, were studied for cases of increase in capital ratio of 2%, 4% and 6%. These shocks create output volatility, which was measured using the standard deviation of output from its steady state.
As seen from the above data, higher capital ratio results in a greater decrease in the output volatility. This decrease becomes even greater for higher liquidity tightening policies.
From an international perspective, if the capital-to-asset ratios for the countries that are members of IMF are compared, then the claims above do look good. The figures for 104 countries are provided in Appendix 3. [2] From the data, we would observe that for 71 countries of the 104, which makes a healthy 68%, the ratio is already 8% or more. Most other countries are also around the 7% mark and hence the norms would not really be a hindrance to growth.
Some key statistics are provided in Appendix 4. [3] The notable aspects are low values of non-performing loans, a high return on assets and an even higher return on equity, and a high percentage of liquid assets. It is interesting to observe that countries like India, Brazil and China, which recovered quite rapidly from the slowdown, have little or no trading income, giving them an advantage over others.
As per RBI, Basel III is not expected to impact the Indian banks much (Hindu Business Line, 2010). However, the situation is not as good for the German banks. Germany's 10 biggest banks may need $141 billion additional capital in order to comply with the new regulations (Huebner & Gould, 2010).
DATA ANALYSIS
We considered 84 Indian banks, of which 23 were private sector banks, 34 were foreign banks and 27 were public sector banks. The relevant data and the banks considered have been provided in Appendix 1. [4] We expect the patterns emerging from our analysis to apply to many developing countries that have similar capital adequacy ratios compared to India.
Capital regulations are such that the foreign banks need to maintain higher capital as they are exposed to greater risk. Private sector banks are somewhat around 15-16% which is slightly higher than the country average of 13% which again might be due to the higher risk, as they need to maintain higher capital.
The interesting part is that public sector banks only have an average CAR of 12-13% under Basel II norms which is even less at 12% under Basel I norms. In fact, this ratio has been boosted by the presence of State Bank of India in the list which has a CAR ratio at least a percentage point greater than the average value.
We proceed to study the factors that affect the capital adequacy ratio (CAR). Risk is the most important component determining CAR (Jablecki, 2009). Since measuring risk is not even accurately possible for banks and also that kind of data is difficult to determine (Pavera & Khatri, 2008), the closest available values that could relate to risk were the credit deposit ratio (CDR) and investment deposit ratio (IDR). There have also been studies linking the amount of capital needed to the net profit of the bank (Akhtaruzzaman, 2009). Since profit is an indicator of the strength of business of the bank, it also affects the amount of capital that must be placed away in order to cover the risks.
Also, we must keep in mind that the risk would be lowest for a public sector bank and the maximum for the foreign banks. The public sector banks have government backing, and hence they are relatively safe.
The overall model has 161 observations and shows significance at the 10% level for all independent variables when the CAR under Basel I is regressed on these parameters. But again, it shows a significant relationship with only net profit and IDR when the Basel II CAR is regressed on the above parameters. Here, once again the significance becomes stronger for net profit in the second regression and it holds even at a 1% significance level.
The model as a whole shows a low R2 value even when all the variables are significant. There is certainly scope for more variables to be included in this model.
Research Question 1: Banks would not be highly impacted with the new CAR as they are already maintaining sufficient capital
Research Question 2: The new Basel norms will slow down growth but the loss due to crisis is far greater and so the norms don't hurt the economy.
LIMITATIONS & IMPLICATIONS
We have only considered 3 parameters for which data was available. The low R2 shows we can include more variables. Also, we could not include data for non IMF member banks. Also since IFRS is new on the scene, hence it is difficult to comment on its long term performance.
CONCLUSION
IFRS implementation process requires time and that's why most countries have provided a 2 years gap between the transition date and the final reporting date (Deloitte, 2008). For banks that are not used to maintaining the required data, they need to start sooner rather than later (KPMG, 2008). It is also difficult to comment whether IFRS would result in positive or negative changes to net income, but what seems certain is that it would make the net income more volatile.
Basel III and IFRS are a step in the right direction. While Basel III tightens the risk management policy of banks and forces them to save for the bad times, IFRS promotes corporate governance and ethical management. Also our results show that as net income is an important parameter, these standards need to co-exist.
