This story appeared in Jim Hamilton's World of Securities Regulation.
Fair value mark-to-market accounting and accounting for loan losses as applied to banks can increase pro-cyclicality and pose a systemic risk, said UK Financial Services Authority Chair Adair Turner, and thus is linked to macro-prudential risk regulation. In remarks at a London conference hosted by the Institute of Chartered Accountants of England and Wales, he noted that no other sector of the economy is remotely comparable to banking in its capacity to be a driver of economic volatility. As a result, accounting standards relevant to banks need to reflect these differences.
On a broader level, the FSA Chair acknowledged the rising tension over fair value accounting between banking and securities regulators, which has spilled over into the accounting standard setters. The banking regulators are convinced that banks are different and that the IASB and FASB must consider this difference. The pure securities regulators, conversely, tend to be more sympathetic to the idea that accounts are for investors and must reflect fair value at all times.
In the Chair’s view, the tension within the accounting standards setters is complicating progress towards the convergence of international accounting standards. The IASB has been sympathetic to the idea that it must be involved in close dialogue with the banking regulators, he noted, while FASB has been wedded to the ``accounts are for investors only’’ philosophy, and to the accompanying belief that banks, in their accounting, should be treated the same as everyone else.
Fair Value Accounting
Chairman Turner recognizes that there is no alternative to mark-to-market accounting for some instruments, that there is information shareholders value in mark-to-market accounts, and that there is danger in allowing the freedom to switch accounting approaches to hide problems. In addition, he knows that there are many instruments for which there is no feasible alternative to a fair value approach. For example, it is almost impossible for derivatives to be dealt with in any other fashion since concepts of historic cost, nominal value or incurred loss cannot help gauge the economic substance of the risks inherent in a derivative.
However, he also believes that too widespread an application of mark-to-market accounting can exacerbate system volatility. The mark-to-market approach recognizes unrealized gains or losses, which, when applied to illiquid securities, can drive harmful volatility in both upswings and downswings. The fundamental problem is that there are no definitive facts about value.
Rather, value in financial markets is contingent on specific circumstances and on the action of all other participants.
For an individual bank selling slices of its individual portfolio in conditions where the actions of other banks can be considered independent, mark-to-market accounting provides meaningful facts and a useful management discipline. But if all banks simultaneously try to sell all or a significant proportion of their assets, the facts become quite different. And a fully transparent system of across the board mark-to-market accounting could simply increase the speed with which self-reinforcing assumptions about appropriate value generate herd effects.
The FSA recommends limiting the use of fair value accounting in the income statement to the areas of the trading book where it is most appropriate and, in particular, to trading activities in markets likely to remain highly liquid in nearly all circumstances. The way forward also requires a parallel look at the appropriate coverage of fair value approaches to the definition of profit or loss, ensuring that fair value gains or losses affect profit and loss only where instruments are liquidly traded, and are likely to be liquidly tradable in almost all circumstances.
The Chair pointed out that current accounting standards base loan loss provisions on evidence of already current credit impairment and do not allow for reasonable judgments on future potential losses. He welcomes the increasing dialogue between the IASB and regulators, particularly the IASB’s consultation on a new version of IAS 39, which would require loans on balance sheet to bear an economic loss provision, rather than recognizing losses solely according to the existing incurred loss approach. In principle this approach has merit, he said, but the devil is very much in the details and, in particular, in the detail of how economic loss will be calculated.
If it is calculated by reference to current market expectations of future losses, there is a danger that the new approach could actually be more pro-cyclical than the past. In extremis, if expected losses are calculated by reference to the market prices and spreads of traded credit securities, then an expected loss approach to the banking books becomes a form of mark-to-market by another name, potentially increasing rather than reducing pro-cyclicality.
Conversely, if, as regulators would generally prefer, expected loss is calculated by reference to judgments about future possible losses informed by past experience or by formulae which link provisions to broad indicators of likely future credit problems, some investors might have concerns about whether these judgments, whether made by the management or by the regulator, are based on fact and are transparently understandable.
The FSA recommends allowing the banking book to reflect a more forward looking approach to loan losses. Ideally, the FSA would like to see two separate lines of account information on loan loss provisions. The first line is the existing line, as now.
The second line is a separate line based either on a formula that uses a dynamic provisioning model permitting more mechanical increases to loan loss reserves based on loan growth rather than measures of projected loss, or on the judgments of management, challenged by regulators, and with the details, basis and rationale for that judgment extensively disclosed. If this ideal approach is not followed, careful disclosure of the judgments made in the development of the single economic loss line will be essential.
Two separate lines and extensive disclosure would, the FSA believes, provide better information to investors than either the current incurred loss line or any one expected loss based line could ever provide.
The current IASB accounting treatment requires banks to recognize the implications for potential loan losses of events which have already occurred, such as failures to make interest or principal payments; but also requires them only to recognize such known events, not to anticipate possible or probable future events. This necessarily implies that loan loss provisions will vary dramatically through the economic cycle, and means that in good years income will be declared which does not reflect the average future loan losses likely to arise from loans being put on the books. As a result, this accounting treatment can contribute to a cycle of self-reinforcing responses which tends to exacerbate the volatility of credit extension and of the economic cycle, both on the way up and the way down.