Among the many publications that the EBA posted on its website last week, the Technical advice to the Commission (EC) on the treatment of unrealized gains deserves attention. Not only because of its content, but also because of the clarity, depth, and breadth of covering the issue of unrealized gains.

Here is the context: EBA’s advice on unrealized gains attempts to resolve an issue that originates from two distinct, often colliding, views on the concept of gains. On the one hand is the accounting view, which compares current values with past values to measure gains. On the other hand is the economist view, which looks at current and future values to measure gains. This view ignores the past, it has no memory.

Both views on gains are fundamentally incompatible. The forward-looking economist will see gains fundamentally different from the accountant, who looks at the past.

This incompatibility between the accountant’s and the economist’s view on the concept of gains creates the rub called unrealized gains (and unrealized losses).

Why this advice: The controversy on unrealized gains and losses gained momentum when the IASB planned its overhaul of the accounting standard on financial instruments (IAS39) in the spring of 2008. IAS39 has an awkward rule that allows firms to record gains according to the accountant’s and the economist’s view, that is, mainly for assets in the available-for-sale category.

To reconcile both views on gains, IAS39 then requires the difference between them to be recorded in a reserve account called Other Comprehensive Income (see IAS39 para 55 (b)).

However, recording the difference in a reserve account is quite meaningless. It is like mixing water and oil. As a result, it does not solve the real problem: both views on gains remain fundamentally incompatible.

This incompatibility and ill-designed IAS39 prompted banks to use the reserve account to their advantage. They relied on it to boost their reported solvency ratios. Bank regulators retaliated and excluded the reserve account from capital; see the EBA-CEBS Guidelines on Prudential filters that complemented the introduction of IFRS in Europe.

In November 2009, the IASB banned the funny reconciliation reserve account when it published IFRS 9, the successor of IAS39. However, and unfortunately, a month later, the Basel Committee made a mistake. Instead of excluding the reserve account, the committee deliberately included it as an item of regulatory capital, albeit by way of a footnote on page 13 of the Basel III rules text. Including the reserve account may work fine for unrealized losses, i.e. when the reserve account is negative. However, for prudential reasons, unrealized gains should probably be excluded from capital.

This is what the EBA Advice to the Commission now tries to achieve.

What the advice purports. The EBA advice overturns Basel III and its EU implementation in Article 35 of the CRR on the inclusion of unrealized gains in regulatory capital.

The advice recommends the exclusion of unrealized gains from banking book items, as these gains can be tracked more easily by the accounting system. In addition, current bank solvency rules do not require banks to hold capital for market risk. Excluding unrealized gains from banking book items thus makes sense. (EBA exempts trading book items form the exclusion, for the same reasons, but also because trading book gains are more liquid, these gains are generally “in the money”, and thus are less sensitive to problems of illiquid markets.)

To keep matters simple, the EBA recommends no separate treatment of unrealized gains between available-for-sale debt and available-for-sale equity.

However, there is one catch: EBA recommends a more prudent treatment of gains on investment properties and real estate. Here EBA recommends the exclusion of unrealized gains on an item-by-item basis, which may be burdensome because it requires tracking the values and changes therein of each individual item.

Implementation: The EBA advice dovetails with the expected introduction of IFRS 9, expected by 1/1/2015, and the transition period of the Basel III implementation in Europe, next week, via the CRR.

EBA notes that the CRR establishes a transition period – from 1 January 2014 to 31 December 2014 – during which unrealized gains reported on the balance sheet shall continue to be fully removed from capital (from CET1). This continues the current situation: current EU bank rules generally ban the inclusion of unrealized gains. Then, after 31 December 2014, the CRR gradually phases in the unrealized gains.

Consequently, no unrealized gains shall be recognized in CET1 during 2014. EBA’s understanding is that during 2014 the EC will consider the technical advice to assess id if it should change the CRR.

Note that EBA reminds us that we are in Europe, where banks hold sovereign debt: CRR Article 467(2) empowers the competent authorities, in cases where such treatment was applied before 1 January 2014, to allow banks not to include in own funds the unrealized gains or losses on exposures to central governments classified as available-for-sale until the EC adopts IFRS 9.

Will it be effective? The advice repairs a flaw in Basel III. However, its prudential effectiveness remains to be seen. For example, the portfolio approach limits its effectiveness, but the alternative: grossing up all positions, is probably an implementation nightmare.

In addition, there is a level playing field: other countries do allow the inclusion of unrealized gains. However, the U.S., for example, applies double standards on the inclusion of unrealized gains: the rule on inclusion of unrealized gains and losses only applies to large banks, see my earlier post.

What I like about the advice. Even though this advice may be limited in its effectiveness, I like it. The reason is that it goes the extra mile in explaining how unrealized gains (and losses) work at banks. The advice comprehensively and thoroughly investigates many, if not all, aspects of unrealized gains: how the interact with liquidity standards, with capital requirements, with standards on prudent valuations, etc. For this reason alone (but not exclusively), it is definitively worth a read.