Fair Value Accounting Questions the Purpose of Banking

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The first time I heard about the proposed fair value rules for financial institutions, my gut reaction as a valuation expert was “they will never do that; it would turn a market downturn into a full-blown banking panic.”  Well, I was half-right …unfortunately it was the latter half.  Fair value reporting was adopted, and many think it helped turn the investment mistakes of some institutions into a systematic crisis of the financial system in the fourth quarter of 2008.  Others counter that if it had been in place earlier, the crisis may have been prevented.

 

The issue of fair value for financial institutions is at the nexus of several issues affecting banking and accounting.  One is the differing views of the accounting profession and the financial industry on how to best measure the performance of a bank.  The second is the difference between the Continental European model of banking and the “Anglo-Saxon” banking model.  This affects International Financial Reporting Standards (IFRS), creating issues with the project to create convergence between GAAP and IFRS.  Finally there is the changed reality of how banks were regulated for most of the 20th century, and the rules they operated under in the first decade of the 21st century. 

 

First, the accounting profession is affected by the relentless push by the FASB for expanding the use of fair value measurements in financial reporting.  The FASB essentially wants almost all bank assets to be measured at fair value.  The logic is simple:  banks are essentially portfolios of financial assets, and investors need to know what those assets are worth on the date of the financial statement.  To put it in football terms, the FASB wants to know what the score of the game is at the end of each quarter.   Sound simple, right?  Not so fast…

 

Financial Executives International (FEI) a US trade group for financial professionals says that isn’t the way to measure performance, especially of a bank’s loan book.  FEI’s committees studying fair value “are strong proponents of an amortized cost model for financial instruments that are held for their contractual cash flows and support the IASB’s (International Accounting Standards Board’s) approach in this regard. Such a model ensures both accounting and economic symmetry between financial assets and liabilities because it inherently considers an enterprises’ business model (how the financial instruments will be managed to produce returns for investors). For these reasons, amortized cost remains the most relevant measure for financial assets held for investment or managed for the foreseeable future. We believe an amortized cost model, coupled with the right credit impairment and interest income recognition guidance and supplemental quantitative and qualitative disclosures, will better align accounting with the metrics used to evaluate the performance of such financial assets.”[1]

 

 What FEI is saying is that “in cases where the business strategy is to hold the financial asset ... fair value will result in artificial volatility that will not be realized; as such, fair value would not reflect economic reality.” [2]  The logic here is that if you have no intention of selling the loan, the only thing that matters is that the borrower keeps paying the interest and principal on a regular basis, no matter the ups and downs of the markets.  Fair value accounting’s incorporation of market value fluctuations into the income stream would just obfuscate the real earning power of the loan portfolio.  To use our football analogy, the only thing that matters is the final score; it doesn’t matter if the market thinks we are down at halftime.

 

This conflicts with another big issue in the accounting profession, the push toward convergence of US GAAP with IFRS.  The IASB advocates a mixed measurement model, which would enable some assets to be valued at amortized cost.  So literally speaking, this is becoming an international incident.

 

These differences in accounting preferences derive from deep-rooted differences in the financial cultures of Continental Europe versus the “Anglo-Saxon” countries.  In Continental Europe, there has historically been a relationship banking model where banks often have board seats and own equity stakes in their customers.  So if a company has difficulty repaying a loan, the bank is intimately involved in restructuring the business.  This is often done without any formal bankruptcy filing or legal proceeding.  No wonder the Continental European banks have influenced the IASB to support an amortized cost model for loan valuation

 

In Anglo-Saxon banking cultures, banks are less likely to be intimately involved in the management of their clients’ businesses.  Loan repayment was ensured to a higher degree by the more developed Anglo-Saxon legal system, with its sophisticated law of contracts and bankruptcy.  In addition, the Anglo-Saxon financial system had more advanced capital markets, where a bank could reduce its exposure to the risks of a financially weak client by syndicating the risk to other banks.  A loan becomes more of a commoditized security under this system.

 

Finally, the changes in our financial system in the 21st century have complicated matters further.  The repeal of the Glass-Steagall Act during the Clinton Administration combined with the explosive development of the mortgage securitization industry essentially converted much of traditional banking into something that more resembled Wall Street investment banks.  Banks began to look at loans as something one originated, packaged and sold for a fee (or traded for income), not as a long-term business asset.  So it is natural for the FASB to view the loan book as simply an investment portfolio that should be marked to market on a regular basis.

 

So ultimately fair value accounting demands an answer to the question of what is the purpose of a bank.  If a bank is simply an originating, packaging and distribution machine for loans, the FASB’s approach has merit.  If a bank is something more, a business partner who adds value to its portfolio by working out problems with borrowers over the life of the loan, the IASB approach might be more applicable.  The resolution of this issue deserves careful consideration, as it will affect global finance and industry for the rest of the century.

 

 


[1] FEI comment letter to the FASB, September 1, 2010.  http://www.fasb.org/cs/BlobServer?blobcol=urldata&blobtable=MungoBlobs&b...

[2] Ibid.

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