Fair value –or mark-to-market — accounting is back in the news.
The IASB and FASB, the European and US accounting standards boards, are reportedly grappling over global accounting convergence because of the issue. From the FT:
Fair value accounting has proved one of the most divisive issues. Supporters, who include large US investors, say it provides the accurate snapshot of a company’s value that is necessary to make investment decisions. However, regulators and policymakers, particularly in Europe, have argued that the practice of valuing financial instruments, such as derivatives, at fair value exacerbated plunging asset values during the crisis.
By sheer coincidence, an article by Christian Laux and Christian Leuz in the latest edition of the Journal of Economic Perspectives deals with the same topic, asking: Did fair-value accounting contribute to the financial crisis?
Their answer is no — but not for the reasons you might think.
According to the authors:
For U.S. bank holding companies, the effect of fair-value changes on bank income and regulatory capital (in booms or busts) is much more limited than often claimed. Moreover, during the crisis, banks made ample use of the safeguards and discretion built into fair-value accounting. For instance, many banks with substantial real-estate exposure and large trading portfolios used cash-flow-based models to value their mortgage-related securities by the third or fourth quarter of 2007. The notion that marking to market pricing was widespread among U.S. banks is simply a myth as far as mortgage-related securities are concerned. Moreover, using various benchmarks, we find little evidence that banks’ reported fair values suffered from excessive write-downs or undervaluation in 2008, which in turn could have contributed to downward spirals and contagion. If anything, the evidence points in the opposite direction—that is, towards overvaluation, particularly when banks have more discretion in determining fair value.
So fair value didn’t exacerbate the crisis because banks weren’t actually marking-to-market that much.
In fact, according to the authors, for big banks just 36 per cent of assets were reported at or close to fair value between 2004 – 2006. Another 50 per cent of total assets were subject to fair value disclosures in the notes to the banks’ financial statements — but didn’t necessarily feed into the bottom-line P&L figures.
The number of assets being held at fair value shifted considerably during the financial crisis.
Even with fair value accounting in place, banks have a significant amount of discretion as to what they actually classify as FV. For instance, by reclassifying loans as held-for-investment (accounted for at amortised cost) rather than held-for-sale (FV) they can avoid having to mark them to market.
As the US mortgage market began to implode from 2007 onwards, banks made full use of that discretion. For example, in the fourth-quarter of 2008, Citi reclassified about $60bn of debt securities to held–to-maturity.
Banks also began classifying more and more of their assets as Level III, which mostly uses internal models to come up with pricing instead of active market ones (Level I) or some sort of combination (Level II).
That might have been natural during the crisis – when market prices for a lot of securities simply didn’t exist – but it meant they had even more leeway to provide their own evaluations, the authors say. Surprise, surprise there’s some evidence they tended to overvalue them. The steady march from Level I to Level III can be seen below:
So the basic idea is that FV couldn’t really have exacerbated the crisis, because everyone avoided using it as much as they could, even before the subprime meltdown. The mortgage-related assets that lay at the heart of subprime troubles, the authors note, were rarely classified as Level I, or based on market prices.
Where then do the authors stand on the FV issue?
While the claim that fair-value accounting exacerbated the financial crisis appears to be largely unfounded, our analysis should be interpreted cautiously and not be viewed as advocating an extended use of fair values. It is possible that the role of fair-value accounting was limited precisely because its relevance for banks’ balance sheets and capital requirements was limited. Moreover, there are tradeoffs: on one hand, marking assets to market prices can in principle exacerbate downward spirals and contagion during a financial crisis; but on the other hand, a faster recognition of losses provides pressures for prompt corrective action by banks and regulators and likely limits imprudent lending in the first place. We need more research and empirical evidence to guide reforms of the accounting rules and bank regulation.
It’s not much help to IASB and FASB right now, then, but it is worth mentioning as the two boards struggle to come to some sort of fair value agreement.
(H/T The FT’s Robin Harding for the JEP article)
Related links:
Fair value foresight and equity destruction – FT Alphaville
A smooth IASB and an impairment change – FT Alphaville
Accounting stress – FT Alphaville