All's Fair

SO CONTROVERSIAL has accounting become that even John McCain, a man not known for his interest in balance sheets, has an opinion. The Republican candidate for the American presidency thinks that "fair value" rules may be "exacerbating the credit crunch". His voice is part of a chorus of criticism against mark-to-market accounting, which forces banks to value assets at the estimated price they would fetch if sold now, rather than at historic cost. Some fear that accounting dogma has caused a cycle of falling asset prices and forced sales that endangers financial stability. The fate of Lehman Brothers and American International Group will have strengthened their conviction.

In response America's Financial Accounting Standards Board (FASB), and the London-based International Accounting Standards Board (IASB) have not budged an inch. So, for example, banks will have to mark their securities to the prices Lehman receives as it is liquidated. The two accounting bodies already act cheek by jowl, and America will probably soon adopt international rules. Are they guilty of obstinately pursuing an abstract goal that is causing mayhem in financial markets?

Banks' initial attack on fair value was self-serving. In April the Institute of International Finance (IIF), a lobbying group, sent a confidential memorandum to the two standard-setters. This said it was "obvious" markets had failed and that companies should be allowed to suspend fair value for "sound" assets that had suffered "undue valuation". Even at the time this stance lacked credibility; Goldman Sachs resigned from the IIF in protest at "Alice in Wonderland accounting". Today it is abundantly clear that those revelations were not a figment of accountants' imagination. For example, in July Merrill Lynch sold a big structured-credit portfolio at 22% of its face value—less than what was entered on its balance sheet. Bob Herz, FASB's chairman, argues that fair value is "essential to provide transparency" for investors.

Yet not all criticism of fair value can be so easily dismissed. The credit crunch has raised three genuinely awkward questions. The first of these concerns "procyclicality". Bankers say that in a downturn fair-value accounting forces them all to recognise losses at the same time, impairing their capital and triggering firesales of assets, which in turn drives prices and valuations down even more. Under traditional accounting, losses hit the books far more slowly. Some admire Spain's system, which requires banks to make extra provision for losses in good times, so that when loans turn sour their profits and thus capital fall by less.

It is too soon to know if prices exaggerate the ultimate losses on credit products. Some people argue that swift write-downs in fact help to re-establish stability: Yoshimi Watanabe, Japan's minister for financial services, says Japanese banks exacerbated their country's economic woes by "avoiding ever facing up to losses". But the principle defence of standard-setters is that enhancing financial stability is not the purpose of accounting.

Over to the regulators
In other words, if procyclicality is a problem, it is someone else's. Already central banks have relaxed their rules on what they will accept from banks as collateral, which has helped to support the prices of risky assets. And the mayhem in the swaps market has shown the importance of on-exchange trading, so that trading remains orderly in times of stress.

Ultimately, though, responsibility for interposing a circuit-breaker between market prices and banks' capital adequacy falls on bank regulators, not accountants. They are already examining "countercyclical" regimes, which would force banks to save more capital in years of plenty. They could go further by suspending capital rules during times of stress if they think asset prices have overreacted. Europe's national regulators already use some discretion when defining capital adequacy. There is a precedent in pension regulation, where corporate schemes are marked to market but the cash payments companies make to keep them solvent are smoothed over time. Banks' financial statements could be modified to show assets at cost as well as fair value, so that if regulators or investors wanted to use traditional accounting to form a view, they could.

Even if they leave procyclicality to bank regulators, standard-setters still have a lot on their plates. The second — and immediate—question is how to value illiquid (and sometimes unique) assets. A common solution is to use banks' own models. But some investors are concerned that this gives banks' managers too much discretion — and no wonder, because highly illiquid (or "Level 3") assets are worryingly large relative to many banks' shrunken market values. Such is the complexity of many such assets that it may not be possible to find a generally acceptable method. The best answer is to disclose enough to allow investors to form their own views. This week IASB gave new guidance which should help in this regard.

The third problem is a longer-term one: the inconsistency of fair-value rules. Today the treatment of a financial asset is determined by the intention of the company. If it is to be traded actively, its market value must be used. If it is only "available for sale" it is marked to market on the balance sheet, but losses are not recognised in the income statement. If it is to be "held to maturity", or is a traditional loan, it can be carried at cost, subject to impairment. This is a dog's breakfast. Different banks can hold the same asset at different values. According to Fitch, a ratings agency, at the end of 2007, Western banks carried about half of their assets at fair value, but the dispersion was wide: from 86% at Goldman Sachs to 27% at Bank of America (see chart).

• 1
• 2
• next »