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UK FSA warns of an 'accounting mismatch'

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10 Mar 2010

The United Kingdom's Financial Services Authority (FSA, the banking and securities regulator) has published a report Financial Risk Outlook 2010.

The report cautions financial institutions that 'accounting mismatches' have the potential to report profits in a deteriorating economy – which the FSA is predicting. This could happen because accounting allows asset-backed securities to be measured at amortised cost while related credit default swaps are measured at fair value through profit or loss. FSA reminds financial institutions to be clear in their disclosures about this.

The future evolution of risks may be misinterpreted due to accounting mismatches. Accounting mismatches created by the different treatment of trading books and banking books create the danger that the future evolution of risks will not be clearly understood and communicated. Prior to the crisis, many banks and investment banks executed negative basis trades, holding asset-backed securities (ABS) and buying CDS [credit default swap] protection against them. Both parts of the trade were initially held in the trading book. Subsequently, some banks have – under permitted accounting treatment – transferred the ABS to the banking book, while leaving the CDS in the trading book. Under this treatment, any future deterioration in the economy, with a resulting widening of credit spreads, will deliver an immediate profit in trading books, with ABS values unchanged in the banking books, until actual default leads to impairment of assets.

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