Accounting Treatment of Specific Items under accounting policies of banks

The term “accounting treatment” represents the prescribed manner or method in which an accountant records and presents a specific business transaction or event in the establishment’s financial statements. The accounting policies of Banks require banks to disclose the key areas of operations in one place (under Schedule 17) along with notes to accounts in their financial statements. A suggestive list includes the basis of Accounting, Transactions involving foreign exchange, Investments – classification, valuation, etc., Advances and Provisions thereon, Fixed Assets and Depreciation, Revenue Recognition, Employee Benefits, Provision for Taxation, Net Profit, etc. Banks must include all balance sheet items in their exposure measure. A bank’s total exposure measure includes the sum of the following exposures:

• on-balance sheet exposures;
• Derivative exposures;
• securities financing transaction (SFT) exposures; and
• Off-balance sheet (OBS) items.

On-balance sheet Exposure: Balance sheet exposure can be mitigated by identifying, quantifying, and evaluating transaction-level balances. The timing and amount of the exposure should be matched by a hedge to eliminate the impact on income.

 Derivative exposures:

 Treatment of derivatives: Derivatives create two types of exposure:

(a) An exposure arising from the underlying of the derivative contract; and

(b) A counterpart Credit risk (CCR) exposure.

The leverage ratio framework uses the method set out to capture both of these exposure types.

 Banks must calculate their derivative exposures, including where a bank sells protection using a credit derivative, as the replacement cost (RC) for the current exposure plus an add-on for potential future exposure (PFE). If a derivative exposure is covered by an eligible bilateral netting contract, a specific treatment may be applied. The Written credit derivatives are subject to an additional treatment. If a bank acts as the clearing member for a client to a CCP, it must calculate its related leverage ratio exposure. Current credit exposure is determined by the mark-to-market value of the derivative contract. If the mark-to-market value is positive, then the current credit exposure equals that mark-to-market value. The exposure measure for the leverage ratio should generally follow the accounting value. Banks must include all balance sheet assets in their exposure measure, including on-balance sheet derivatives collateral.

Securities financing transaction (SFT) exposures:

Securities Financing Transactions (SFTs) exposures are a type of financial risk that can pose a threat to financial stability. SFTs are transactions that involve the exchange of assets for cash, where the assets are used as collateral to secure funding. SFTs can pose risks because they can lead to maturity and liquidity mismatches, and can be used to take on leverage. The treatment of Securities financing transaction exposures recognises that secured lending and borrowing in the form of SFTs is an important source of leverage, and ensures consistent international implementation by providing a common measure for dealing with the main differences in the operative accounting frameworks. When a bank acts as a principal, its SFT exposure is the sum of gross SFT assets (subject to adjustments) and a measure of counterparty credit risk calculated as the current exposure without an add-on for potential future exposure. Where a bank acting as an agent in an SFT does not provide an indemnity or guarantee to any of the involved parties, the bank is not exposed to the SFT. It therefore need not recognize those SFTs in its leverage ratio exposure measure. In situations where a bank is economically exposed beyond providing an indemnity or guarantee for the difference between the value of the security or cash its customer has lent and the value of the collateral the borrower has provided, a further exposure equal to the full amount of the security or cash must be included in the leverage ratio exposure measure.

Treatment of Off-balance sheet items:

The off-balance sheet (OBS) items are;

1. Letters of credit,
2. a bank guarantees a customer’s payment to a third party, but reports it as a memo entry instead of a loan,
3. Loan commitments like a bank agrees to lend money in the future if certain conditions are met, but it’s not recorded as an asset until the funds are disbursed,
4. Credit derivatives where banks transfer loan risk to an investor through credit default swaps and other derivatives,
5.  Leasing machinery is where a company leases machinery from an external source instead of purchasing it.

For the treatment of the OBS, the add-on for each asset class is calculated using formulas specific to that asset class. The term ‘Add-on’ generally represents the volatility of the derivative exposure and it is the notional principal amount of the underlying asset with a weighting applied to it. The weighting depends on the asset type and maturity. In the context of Potential Future Exposure (PFE), “add-ons” are intermediate measures of exposure that are combined to calculate PFE. The add-ons are then aggregated to form hedging sets and counterparty netting sets. The final step is to offset the aggregated amount by the counterparty’s collateral. The bank must calculate PFE for each netting set as a simple summation of the add-ons computed for each asset class within that netting set.