18 CHAP T E R 2 What Is Capital Management?

seem confusing, since very few would probably agree to consider book value the true
economic value of a bank. Nevertheless, apart from recalling the broader denition of
economic capital we adopted here, it is not uncommon to see banks presenting their avail-
able economic capital versus their MRCR and their internal estimate of economic
capital compared with their book value of equity.
The point we want to make is that when measuring economic capital, that bank could
compare either its book value of equity with the amount of book value that can be
destroyed under adverse scenarios (i.e., its book capital at risk) or, similarly, its current
market capitalization with its market capitalization at risk. This may also imply a dif-
ferent measure of risk for different businesses. Failing to capture the difference could
imply, for instance, comparing available capital, which is typically measured as book
value of equity, with a measure of economic capital that has been calculated in an incon-
sistent way.
Of course, the information conveyed by the book value of equity and its link with the
true value of the bank also depends on the kind of accounting principles adopted
in the individual country. From this point of view, a relevant issue for most European
banks has recently been represented by the new International Accounting Standards/
International Financial Reporting Standards (IAS/IFRS) issued by the International
Accounting Standards Board (IASB). The IASB is an international organization compris-
ing representatives of nine countries aimed at developing internationally accepted uniform
accounting standards, representing an international equivalent of the U.S. FASB (Finan-
cial Accounting Standards Board). Principles issued by the IASB are not binding by
themselves, but they need to be translated into law by individual countries. The European
Union has issued a set of regulations adopting fully (or at least largely) the new principles,
which will be mandatory for listed banks (while national rulemakers also have the option
to extend it to nonlisted ones).
A detailed discussion of the new accounting principles is beyond the scope of this
book, especially since their impact may vary from country to country (depending on
preexisting accounting rules, on whether and how the new principles would be translated
into legislation, and on how some principles will be applied in practice in certain areas).
Yet, with a certain level of simplication, we may point out the main areas that will be
affected for those banks that will be subject to the new principles:
1. Hedge and derivative accounting
2. Loan-loss provisions and valuation
3. Insurance businesses in bancassurance groups
Other issues are related to pension plans, leasing contracts, and share-based compensation
accounting and to the distinction between goodwill and intangible assets in acquisitions
and their consequent amortization treatment.
Hedge and derivatives accounting is affected because principle IAS39 remarkably
restricts the number of cases in which derivative positions may be recognized at cost in
the banks nancial statement rather than at fair value. This change depends partly on the
new and stricter criteria that must be met to classify a derivative position as a hedge for
banking book items and partly on the new classication of nancial instruments, which
are divided into four classes (loans and receivables, held for trading, held to maturity,
available for sales), in which assets classied as available for sales, which before IAS/
IFRS would have been evaluated in many countries taking cost into consideration, are
now also evaluated at fair value. As a consequence, higher volatility of the banks nancial
performance should be expected, and even higher importance should be given to the check
of fair value estimates for derivative positions.
The second area (loan-loss provisions and loan valuation) is particularly important
from a risk management point of view; this is discussed further in Chapter 4, on credit
risk. Anyway, the key issues stem from the following:
1. Loans have to be evaluated at amortized cost (unless the bank decides to evaluate
all loans at fair value), implying that the effect of initial costs or fees should be
spread over the life of the loan.
2. A reduction in the value of a loan may be made only in case of impairment,
which can be assessed either analytically (by identifying the individual problem
loan) or collectively on a group of similar loans; banks should provision (or more
precisely, recognize a reduction in loan value) only as a consequence of incurred
losses, not just expected ones, even if some adjustment may be possible in practice
when evaluating collective impairment.
3. When estimating the effects of impairment (and hence making provisions), the
bank should consider for non-short-term loans the reduction of future expected
cash ow, to be discounted at the original interest rate of the loan.
4. In any case, the bank should disclose to the market the estimated fair value of all
loans (even if they are evaluated at amortized cost in the balance sheet).
The main issues here stem from the fact that item 2 implies that generic provisions used
to anticipate greater future losses when at the end of a benign economic cycle, and to
smooth earnings as well, are ruled out. But this has to be reconciled with regulators
concerns that a bank could maintain adequate provisions to cover expected losses. On the
other hand, item 3 implies that in those cases where the borrower is in default, the loss
that has to be recognized by the bank as a consequence is not necessarily equal to how
regulators or risk managers would dene their loss-given-default (LGD) concept (since,
for instance, the discounting rate may differ). These issues are discussed in Chapter 4.
Insurance business treatment has not been fully dened so far by the IASB due to the
inherent complexity of the topic. While a rst relevant principle, named IFRS4, has
already been approved, it is still at present unclear when and to what extent the fair value
principle should be applied to insurance companies liabilities, especially for those insur-
ance products implying a nontrivial actuarial risk. This is a potentially relevant issue for
some banking groups with signicant insurance subsidiaries, even more so for nancial
conglomerates, also depending on the product mix of the insurance company.
In general, a potential consequence for those countries moving toward IAS/IFRS
implementation may therefore be a greater volatility in book values (and hence also indi-
rectly affecting Tier 1 capital), even if the advantage of reducing the gaps in accounting
treatment with U.S. generally accepted accounting principles (GAAP) may also be rele-
vant for the indirect effects on Tier 1 capital size and stability.
2.3.2 Market Capitalization and the Double Perspective
of Bank Managers
However relevant book value may be, when a manager states that value creation is the
overall objective of the bank, the crucial concept of value is represented by market
value rather than book value of equity. Market value of equity, or market capitalization
BANK E S T I MAT E S OF R E QUI R E D CAP I TAL 19