Enhance the Disclosure of Off-Balance Sheet Transactions for Financial Institutions

1. Enhance the Disclosure of Off-Balance Sheet Transactions for Financial Institutions 7/22/2009 Department of Money and Banking, NCCU Thomas T. Lee

2. Enron leads to Sarbanes-Oxley

3. For off-balance-sheet accounting Used to make a company look like it has far less debt than it actually does Can move debt to a newly created company specifically for that purpose, which was the case with Enron. Companies are called special purpose entities (SPEs) and are also known as variable interest entities (VIEs) Enron fully utilizes SPEs/VIEs

4. Prior to Sarbanes-Oxley • Off-balance-sheet entities created • Finance a business venture but doesn't want to take on the risk • When there is too much debt to get a loan • By starting a new SPE • Can secure a loan through the new entity • Branch out into another area outside of its core business • A SPE will keep that risk from affecting the main balance sheet and profitability of the company • Prior to 2003, a company could own up to 97 percent of an SPE without having to report the liabilities of the SPE on its balance sheet

5. Section 401(a) of the Sarbanes-Oxley Act • Requires that annual and quarterly financial reports disclose all material off-balance sheet transactions, arrangements, and obligations • Also require most companies to provide an overview of known contractual obligations in an "easy-to-read tabular format"

6. Too Late the Sarbanes-Oxley Act

7. Global Financial Crisis • Macroeconomic conditions • Low global interest rates, large increases in asset prices,… • Financial sector regulation • Rapid growth in “subprime” mortgages in US • Repackaging into traded structured products • Origins of the crisis in the US, spillovers to Europe (direct exposures and declines in wholesale funding), emerging markets hit after the collapse of Lehman • Restoring confidence in mature financial systems, dealing with capital flow reversals in emerging markets, addressing the fiscal consequences of intervention in the financial system

8. Banks Have Learned to Use Off-balance Sheet Accounting • “Off-balance-sheet” Methods of Intermediation [Jeffrey Lacker, President, FRB of Richmond (5/11/2009)] • Securitization transfers credit risk from the banks or mortgage companies to a broad array of investors • These arrangements channeled funds to mortgage borrowers without using the general deposit and debt liabilities of banks • Collateralized debt obligations, structured investment vehicles, asset-backed commercial paper conduits all tend to isolate financing from the institution’s own balance sheet

9. Capital-Arbitrage becomes “Boomerang assets” • “Boomerang assets” • Both explicit and implicit, banks stood behind their off-balance sheet arrangements • The loans and other assets that ostensibly were moved off the balance sheet had the ability to come back onto banks’ balance sheets • Donald L Kohn, Vice Chairman of the Fed (4/3/2009) • Uncertainty about the extent of banks' mortgage-related losses and their potential liquidity needs to support off-balance-sheet entities led banks to become much less willing to lend to each other and to other financial institutions • Off-balance-sheet lending for capital-arbitrage purposes has backfired • Commitments are moving on balance sheet quickly and banks must fund these loans and maintain capital for these loans • When internally generated capital is worsening, leaving banks to constrict loan books, to raise capital and to cut dividends

10. International Attitudes towardOff-balance Sheet Activities

11. IMF’s View on Off-balance Sheet Issues • Better Early Warning • Better financial stability analysis • Risks were moved to off-balance sheet vehicles • Risks moved to a burgeoning superstructure of complex marketable products and derivatives and became untraceable • Better macroeconomic analysis • Understand better International financial linkages • Importance of information on: • Off balance sheet entities • Contingent exposures (derivatives) • Maturity of liabilities and assets • Intra-sectoral exposures/market structures • Valuation

12. Report of the Financial Stability Forum on Enhancing Market and Institutional Resilience • Financial Stability Forum (Board) 4/2008 • Capital requirements: • Strengthen the capital treatment of liquidity facilities to off-balance sheet conduits • Oversight of risk management: • Require banks to soundly manage and report off-balance sheet exposures • Standards for off-balance sheet vehicles and valuations: • Standard setters will take urgent action to: • Improve and converge financial reporting standards for off-balance sheet vehicles; • Develop guidance on valuations when markets are no longer active, establishing an expert advisory panel in 2008

13. Follow-up on Implementation(10/2008) • Implementation of recommendations needs to accelerate • Accounting standards setters must conclude their work promptly to enhance and converge guidance on valuation of instruments in inactive markets, and accounting and disclosure standards for off-balance sheet activities and related risks. • Strengthened prudential Supervisory oversight of risk management • The Basel Committee on Banking Supervision (BCBS) is enhancing guidance for supervisory oversight of firm-wide risks and management of specific risks areas such as concentrations, off-balance sheet exposures and securitizations, reputational risk and implicit support, valuations and liquidity risk. The BCBS is also developing principles for sound stress testing practices by the end of this year, which it will reinforce through the Pillar 2 review process • Enhancing transparency and valuation • Using the disclosure framework recommended by the FSF, large financial institutions have substantially expanded their disclosures about risk exposures, valuations, off-balance sheet entities and related policies. A proposed standard of the International Accounting Standards Board (IASB) expected by year-end will set forth enhancements to required risk disclosures about financial activities

14. IASB Response to the Financial CrisisAccounting for off balance sheet vehicles • Consolidation • Some entities may not have accounted for all other entities they control, especially some special purpose entities (SPEs) used for securitization transactions • Tighten up the definition of control so that entities account for all other entities that they control; review how the control notion applies to structured entities (such as SPEs); improve disclosure requirements for entities that rightly remain off balance sheet.

15. Derecognition • Some entities may have stopped accounting for assets they still control. This gives readers an incomplete picture. Users also require more information on an entity’s risk exposure related to assets that are rightly off balance sheet. • Need to review and clarify when entities should stop accounting for assets transferred to other entities and is reviewing the disclosure requirements

16. Taiwan’s Experience on Off-balance Sheet Activities

17. Empirical Results Related to Off-Balance Sheet Activities in Taiwan • Tang (1993) • Off-balance sheet activities are negatively related capital ratio; lower capital ratio implies higher off-balance sheet activities and higher potential risk • Chuang (1995) • Guarantee is (insignificantly) negatively related to bank’s risk • Acceptance is (insignificantly) positively related to bank’s risk • No apparent market discipline on off-balance sheet activities • Wang (1998) • Off-balance sheet activities are negatively related to bank’s total risk and unrelated to systematic risk • Liu (2003) • Derivative transactions have negative impact on bank’s operation risk • Against the general concept of Basle accord on off-balance sheet activities

18. Losses in Practice • Waterland Financial Holding • TCBank 2006-1 2006-2 CBO NT$4.3billion • Taishin Banks’ ABCP defaulted due to Lehman Brothers’ overseas assets more than NT$8 billion • Downgraded to junk by Taiwan Ratings • E.Sun Bank 2007-1 CBO • Polaris and Overseas Chinese Bank 2006-1 CBO (tr C&D) • Industrial Bank of Taiwan (IBT)2005-1 (1st~4th tr) • All above included assets from Lehman, Iceland, Washington Mutuals • Who didn’t lose? • Agricultural Bank of Taiwan lost NT$3.46billion, First Bank NT$ 112 million, China Development Financial Holding, Shin Kong Financial Holding,….

19. Lessons -I • Off-balance sheet operations to take advantage of capital regulation and accounting window dressing should be watchful in the future • From accounting point of view, it is always beneficial to take assets and liabilities off • Regulatory point of view, capital arbitrage is cost-saving and profit-enhancing activities • Moral hazard point of view, off-balance sheet assets and liabilities give opportunities to highlight off-sheet assets and hiding off-sheet liabilities (this is the focus of this workshop) • Financial development point of view, FI’s off-balance sheet activities is equivalent to moving toward to “direct finance” (market-oriented) [a financial policy issue]

20. Lessons -II • “Old fashion”/”Traditional” off-balance sheet activities are not as risky as regulators think • Opaque securitized products, especially including overseas assets in asset pools, hurt domestic financial institutions and investors • SPEs/VIEs not yet a problem to Taiwan’s financial community • Wealth management/Trust Operations should be regulated more carefully • At this juncture, • Financial product awareness is more important • Qualified test for financial product “safety” • Financial Product Review Board? In FI and in FSC? • Risk management of cross-strait financial activities • Macro monitoring of financial soundness