Capital Markets

Could Bank Rules End the Fair Value Debate?

It wouldn't be the first time bank regulators broke from accounting rulemakers to find a solution to dwindling capital reserves.
Marie Leone and Tim ReasonNovember 12, 2008

The fair value accounting controversy could be solved by changing banking regulations, rather than by making further alterations in accounting rules, say accounting experts who floated the idea past President Bush yesterday.

In a letter sent to Bush ahead of the G20 summit he is hosting beginning this weekend, Gerrit Zalm, chairman of the trustees of the International Accounting Standards Board, wrote that IASB and the Basel Committee have expressed a “willingness to explore” a solution to the procyclical problems banks currently face.

Zalm — who is the former deputy prime minister and finance minister of the Netherlands — noted that some observers believe fair value accounting accelerates the downturn of markets by requiring banks and other financial institutions to sell off assets to meet capital requirements, “thus depressing the market further.” Yet, argued Zalm, fair value accounting provides transparency and comparability of financial statements, “an objective that should not be sacrificed.”

Indeed, according to IASB Chairman David Tweedie, the “beauty of fair value accounting…is that it brought [the credit] crisis very very quickly into the open.” Testifying before the British House of Common’s Treasury Committee on Tuesday, Tweedie added that without fair value accounting, subprime lending might still be going on “and the disaster would be even worse.”

Tweedie and other witnesses called before the committee addressed the nexus between fair value accounting and banking regulations, and potential solutions for remedying the attack on fair value. By his lights, Tweedie said that bank regulatory and capital requirements are currently moving in lock step with accounting rules, but that shouldn’t be the case. He said that rulemakers can “break the link” and still provide more leeway for adjusting capital requirements while preserving the integrity of fair value accounting.

As an example, Tweedie elaborated on the talks held between IASB and the Basel Committee of banking supervisors, noting that bank regulators could require that some capital reserves be “undistributable” as a way of creating a permanent rainy day fund. He also said at least one banking supervisor suggested a similar tact, in which regulators would mandate that banks increase their capital requirements when the markets are “exuberant” and ease off the requirements — using a stated formula — in bad times, which is something Spain’s central bankers have done in the past.

Paul Boyle, chief executive of the Financial Reporting Council, told the Treasury Committee that there should be a separation between the way accounting rules and capital requirements operate, similar to the way corporate profits are calculated differently for tax and accounting purposes. “The purpose of accounting is to present an unbiased picture of the financial health of the organization. The purpose of prudential regulation is biased, and it is properly biased,” testified Boyle.

He asserted that banking regulation needs to be biased to protect depositors and insurance policyholders, whereas accounting needs to foster investor confidence and therefore requires unbiased treatment. “They have different objectives, and therefore they can use different numbers,” reasoned Boyle. In fact, bank regulators already use different methodologies to calculate regulatory capital. They start with the financial statements, then adjust them based on their regulatory objectives.

There is precedent in the U.S. for reworking bank regulations to address accounting rulemaking. Witness the changes made after FIN 46 was issued. FIN 46 is the rule that required companies to consolidate special purpose entities in many case, and was issued to deal with the abuse of SPEs.

When FASB issued the new rule interpretation it caused plenty of problems for banks, the most prolific users of the vehicles. Indeed, banks engaged in a mad scramble to avoid consolidating SPEs holding more than a trillion dollars worth of securitized assets on their balance sheets.

Ironically, FIN 46 also seemed to require deconsolidation of trust preferred securities. The problem for the banks: TRUPS, as they’re called, count towards the regulatory capital that the bank holding companies were required to keep on hand by the Federal Reserve. Deconsolidating them would make some banks fall short.

In 2005, the Federal Reserve Board announced an elegant solution: Accounting rules need not apply to banks. “Although [generally accepted accounting principles inform] the definition of regulatory capital, the Board is not bound to use GAAP accounting concepts in its definition of tier 1 or tier 2 because regulatory capital requirements are regulatory constructs designed to ensure the safety and soundness of banking organizations, not accounting designations established to ensure the transparency of financial statements.”

The ruling went on to note that, “In this regard, the definition of tier 1 capital since the Board adopted its risk-based capital rule in 1989 has differed from GAAP equity in a number of ways.” So there is precedent for holding banks to different standards.

The same notion was not lost on the Members of Parliament yesterday, who were made aware during the hearing that the total assets of some troubled banks were a 50/50 split between risky derivative instruments and loans. One MP asked if the debate on fair value accounting masked the real problem — that banks that were suppose to be lending money, instead got involved in holding and trading complex derivative instruments. He suggested that new regulation may be the answer, a law “a bit like Glass-Steagall” in which financial institutions that are chartered to hold deposits that are protected by the government, “are not allowed to do these things.”