Risk Management

What’s More Important than Fair Value? Plenty

Global financial experts are more keen on reining in securitization than stamping out fair value.
Marie LeoneJanuary 20, 2009

The call to shut down fair-value accounting, especially for financial instruments in illiquid markets, may be waning. Despite its vilification by bankers for exacerbating the current financial crisis, fair-value accounting shouldn’t be as big an issue for standard-setters as securitization and consolidation issues, according to a panel of experts meeting today in London.

The panelists from the Financial Crisis Advisory Group (FCAG), assembled by the International Accounting Standards Board and the Financial Accounting Standards Board to provide counsel on what issues rulemakers should focus on over the next year or so, aimed their comments at helping quell the current troubles and averting future ones.

“Consolidation and securitization issues probably are more important by a fair margin than all the discussion and debate on fair value,” opined Jerry Corrigan of Goldman Sachs, who is also former president of the New York Federal Reserve Bank. Corrigan would like to see stakeholders put the financial crisis into the proper context, which includes a sharper focus on off-balance-sheet transactions, including securitization vehicles, as well as supervisor oversight and risk management.

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More important, said Corrigan, is the subtle distinction between risk monitoring and risk management at companies and banks. “Risk monitoring presupposes that the right information is getting to the right people, at the right time.” So if a company is having trouble with risk monitoring, then it is “bound to have very large problems with risk management, whether that is on the managerial side or supervisory side.”

What’s more, Corrigan said that rulemakers and regulators should look more closely at asset valuation and price verification — a position that is far from a call to focus on fair value. He posited that, regardless of the accounting method used by a company or the point it reaches in its business or credit cycle, “there are certain fundamentals that must be associated with asset valuation and price verification — and that includes sound governance.” By his lights, that means “truly” independent and “first class” oversight, backed by substantial resources to get the job done.

Nobuo Inabal, a former executive director of the Bank of Japan, chimed in that he, too, thinks consolidation and de-consolidation efforts are more important than the fair-value debate, mainly because the markets may not always function as efficiently or as transparently as expected. Therefore, clearly delineating what risks could be brought back on to a company’s balance sheet, or taken off, is crucial to an investor’s decision process.

Jane Diplock, chairman of the executive committee of the International Organization of Securities Commissions, was adamant that restoring investor confidence should trump all other rulemaking goals. She insisted that it should be the “number one priority” for standards setters. Even the procyclicality concerns of fair-value accounting, although important, should play second fiddle to investor confidence. To get there, companies need to “put forward a better discussion so numbers don’t stand by themselves in a rapidly changing economic environment,” added Diplock.

Stephen Haddrill, director general of the Association of British Insurers, seemed to agree with Diplock’s assessment of top priorities for standards setters. He said that financial statement users should “understand the thinking of management,” and not just be left with the numbers. As illustrated during the current crisis, some assets are brought back onto the balance sheet to avoid reputational risk. As a result, “investors need to know the rationale behind bringing [those assets] back on to the balance sheet,” and why they were isolated in the first place.

The exacerbation of the credit crisis had less to do with accounting and more to do with “trying to describe a binary event with a probabilistic model,” contended Wiseman Nkuhluk, chairman of the audit committee for AngloGold Ashanti, and former economic advisor to the president of the Republic of South Africa. Consider the credit default swap market, he says by way of example.

If a CDS seller understood the high risk that a rapidly sinking market put on the swap, it would have been priced into the instrument. But CDSs were not priced taking into account a risk like the blow-up of the subprime mortgage market. An unusual event like the subprime crisis rendered market information useless, says Nkuhluk. “[Going forward] our challenge will how to understand that the future is a probabilistic model.”

For his part, former U.S. Securities and Exchange Commission chairman and FCAG cochair Harvey Goldschmid said that the group had reached something of a consensus about keeping fair value accounting, but working to improve it. The former chairman of Deutsche Securities, Toru Hashimoto, reinforced Goldschmid’s comments, saying that while he thought that factors like greed, excess liquidity, and poor risk management contributed to the financial crisis more than flawed accounting rules did, he still thinks that fair-value accounting played a part in the crisis.

On the positive side, fair-value accounting was important for identifying problems in the early stage of the crisis as assets values had to be marked down, said Hashimoto. However, fair value accounting also may have supported the buildup of the asset price bubble, and allowed the creation of the bubble without underscoring the risk behind it, reasons the former executive. “When there is a lot of profit building up, [it is also likely that] risk is building up and may materialize in the future,” he said. That is why Hashimoto would like to see a “dynamic provision” added to either accounting rules or banking regulations, so in good times reserves can be built up, and then drawn upon in a downturn.