Courtesy of Jan Riepe
Legitimacy is a key concern for international standard setters. If transnational actors set standards instead of national democratic authorities, the standard setters might suffer from ‘apparent’ legitimacy deficits. The consequences of an ‘apparent’ legitimacy deficit are low levels of public support for institutions, policies and authorities. Consequently, most international standard setters rely on different processes to mitigate legitimacy concerns for their own standards. Nevertheless, these processes might not be the only challenge to a standard’s legitimacy.
My new study ‘Basel and the IASB’ discusses joint legitimacy of two standard setters that are both highly relevant to international banking regulation. The Basel Committee for Banking Supervision (hereafter, the BCBS) develops the international standards, but it relies heavily on accounting numbers governed by the International Accounting Standards Board (IASB). Therefore, the BCBS’s legitimacy as sound prudential regulator depends on the joint legitimacy of the BCBS and the IASB.
The study first discusses the challenges of joint legitimacy. Based on the political debate on Fair Value Accounting in Europe, it illustrates how deficits arising from a lack of joint legitimacy puts both standard setters under pressure. Additionally, it shows how the prudential regulator developed its own financial accounting system based on the Stress Testing results to reduce its reliance on joint legitimacy.
The question of joint legitimacy is specific to international prudential bank regulation. But the underlying challenges, conflicts, and resolutions also inform other forms of international standard setting.
The challenges of joint legitimacy
Both the IASB (Danjou and Walton 2012) and the BCBS (Peihani 2015; Barr and Miller 2006) individually rely on different measures to ensure their legitimacy in their respective domains. However, individual legitimacy within their own ‘domain’ does not necessarily ensure joint legitimacy. The overall transparency of decisions and processes, as well as checks and balances, add legitimacy independent of the respective regulatory domain, but the procedural participation and proportionality are specific to the target stakeholders and their regulatory objectives.
The BCBS’s stakeholders and guiding objectives do not match those of the IASB. The IASB focuses on transparent standards for financial accounting on capital markets that help equity investors value companies. Thereby, the IASB focuses their standards on valuation usefulness to equity investors. The BCBS, in contrast, focuses on financial sector stability and on banks’ non-residual claimholders, such as depositors and the broader public. The mismatch between these missions inhibits the BCBS’s legitimacy as a prudential regulator when its standards rely on financial reporting numbers that were designed for a different purpose (proportionality) and another audience (procedural participation and transparency).
The reliance on joint legitimacy could be neglected if the BCBS is able to translate financial accounting numbers into meaningful regulatory figures. The BCBS would need to translate value relevant items from the accounting statement into figures that are more conservative, less volatile, and contain sufficient information on valuation uncertainty and riskiness. Such a translation exercise, nevertheless, appears impossible given the information prescribed in the IFRS, as it is argued in the study. The IASB explicitly recognizes that: ‘regulators are not considered a primary user and general purpose financial reports are not primarily directed to regulators or other parties’ (IASBF OB10 and F BC1.20-BC 1.23).
Fair value debate in the light of joint legitimacy deficits
The deficiencies of joint legitimacy can cause intense public pressure and lead to structural changes. In the case of the BCBS, they become especially apparent in the discussion on banks’ fair value accounting (FVA) in Europe during the financial crisis.
According the IFRS 13, FVA refers to the valuation of assets: ‘which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s length transaction’. Consequently, the underlying values in the financial statements constantly adjust whenever prices change in the capital market. Regulators and politicians frequently blamed FVA for increasing the volatility in banks’ regulatory capital because temporary value fluctuations of fair value assets resulted in reporting losses and gains that never materialized. FVA was believed to induce procyclical effects on banks’ regulatory capital that created bubbles and inhibited economic recovery after a crisis (for a detailed summary of this discussion, see Beatty and Liao 2014). Although these effects were counterbalanced by prudential filters, and real evidence for more cyclicality is hard to find, the political pressure on FVA increased during the financial crisis.
The former French President Nicolas Sarkozy initiated a review by René Ricol to assess the conformity of the IAS 39 with the three EU endorsement criteria, a) provision of a ‘true and fair view,’ b) some qualitative criteria, and c) whether it is conducive to the European public good, that is, whether it does not create competitive disadvantages for EU firms. The Ricol report concluded that the IAS 39 put EU firms at a disadvantage compared to US firms. Thereby, it might violate the third endorsement criteria. The property mortgages would need to be held at fair values under IAS 39 but not under the corresponding US standard SFAS 86 (André et al. 2009, pp. 13–15).
The concerns reflect on the IASB’s legitimacy and highlight a contradiction within the IASB’s goals. On the one hand, the IASB aims to develop a single global accounting standard and, on the other hand, the standard should be of high relevance for equity investors. However, the IASB never succeeded in establishing its standards for firms in the US. At the same time, the IASB aims to ensure greater valuation usefulness to equity investors by prescribing stricter FVA standards. In so doing, the IASB accepted potential downsides for its non-primary users, such as regulatory authorities. Nevertheless, by being stricter than US standards, IAS 39 caused disadvantages to EU firms with respect to these other users. Thereby, the IASB risked its EU endorsement.
Following the report, the European G7 representatives required the IASB to bring IAS 39 in line with the US standards immediately to ensure a level playing field. They thereby threatened the IASB’s legitimacy by undermining its technical expert status and its unambiguous EU endorsement. André et al. (2009, p. 14) described the debate as ‘a major blow to the IASB.’ Sir David Tweedie, the head of the IASB, told the UK parliamentary committee that the debate had damaged the IASB.
The IASB quickly adjusted IAS 39, ensured more stakeholder participation, and adjusted its structure. The new monitoring board now comprises different public representatives, e.g. one member of the European Commission as well as one representative of the BCBS as an advising member without formal voting rights. The European Commission also became a major sponsor of the IASB and funded the European Financial Reporting Advisory Group to interact with the IASB on behalf of European interests.
Stress test disclosure to foster prudential legitimacy
At the same time, and also as a consequence of political pressure during the financial crisis, various banking regulators strived for their own legitimacy that does not depend anymore on the joint legitimacy of the BCBS and the IASB.
To rely on more information on the value dispersion of banks’ assets, prudential regulators established an entirely new set of conservative financial disclosures: the prudential stress tests. They established stress tests and disclosed their results on a frequent basis (for a detailed discussion of the stress test designs, see Petrella and Resti (2013), Bischof and Daske (2013)). In these stress tests, the banks value assets not by their average market prices but by explicit potential values for different downside scenarios. The different values for each scenario are displayed separately. Thereby, stress test disclosures yield multiple data points and inform the value dispersion and the reliability of the asset values in downside scenarios. Although scenarios differ from time to time, and the prudential regulator does not commit to providing stress test information periodically, Bischof and Daske (2013) show that even temporary mandatory supervisory disclosures change the voluntary disclosure equilibrium, i.e. banks continue to voluntarily disclose stress test information.
Overall, the legitimacy challenges from transnational standard-setting will intensify with higher degrees of economic and social integration beyond national borders. This intensification also increases the likelihood that transnational standards of different transnational bodies overlap. Whenever these standards overlap, my new study shows that it is not sufficient to consider the legitimacy question in an isolated way. You must also assess the joint legitimacy of the regulations for a specific domain.
André, P., Cazavan-Jeny, A., Dick, W., Richard, C., & Walton, P. (2009). Fair Value Accounting and the Banking Crisis in 2008: Shooting the Messenger. Accounting in Europe, 6, 3–24 (2009). doi:10.1080/17449480902896346
Barr, M. S., & Miller, G. P. (2006). Global Administrative Law: The View from Basel. European Journal of International Law, 17, 15–46 (2006). doi:10.1093/ejil/chi167
Beatty, A., & Liao, S. (2014). Financial accounting in the banking industry: A review of the empirical literature. Journal of Accounting and Economics, 58, 339–383 (2014). doi:10.1016/j.jacceco.2014.08.009
Bischof, J., & Daske, H. (2013). Mandatory Disclosure, Voluntary Disclosure, and Stock Market Liquidity: Evidence from the EU Bank Stress Tests. Journal of Accounting Research, 51, 997–1029 (2013). doi:10.1111/1475-679X.12029
Danjou, P., & Walton, P. (2012). The Legitimacy of the IASB. Accounting in Europe, 9, 1–15 (2012). doi:10.1080/17449480.2012.664396
IASB. IFRS Conceptual Framework.
Peihani, M. (2015). The Basel Committee on Banking Supervision: A post-crisis assessment of governance and accountability. Canadian Foreign Policy Journal, 21, 146–163 (2015). doi:10.1080/11926422.2014.934870
Petrella, G., & Resti, A. (2013). Supervisors as information producers: Do stress tests reduce bank opaqueness? Journal of Banking & Finance, 37, 5406–5420 (2013). doi:10.1016/j.jbankfin.2013.01.005
 Although stress test disclosures go back to the different prudential regulators and are implemented differently by each regulator, there are similar approaches for all major participants of the BCBS (Petrella and Resti (2013)).