In recent months, the impact of fair-value accounting (also known as mark-to-market accounting) on financial institutions and the capital markets has been the focus of considerable controversy. An equally controversial topic is the manner in which banks record losses in their loan portfolios. Last week Grant Thornton LLP issued a proposal that can (1) enhance the safety and soundness of financial institutions in difficult economic times and (2) preserve the benefits to investors of the current accounting model. Grant Thornton’s proposal, summarized below, was submitted via letter to the U.S. Department of the Treasury, the Federal Reserve and the Federal Deposit Insurance Corporation.
In summary, Grant Thornton proposes that bank regulators exercise their authority to adjust capital requirements to account for different economic environments, thus providing "dynamic regulatory capital provisioning." Taking this approach would increase capital requirements in booming economies and decrease those requirements in strained ones. The advantages of such an approach are many:
- In prosperous economies, financial institutions often invest in increasingly risky assets in order to drive income and compete in the marketplace. An increase in the overall capital requirements in such economies would serve as an effective braking mechanism by reducing the capital available for potentially excessive risk-taking. Further, the reduction in excessive risk-taking would redirect public investment in these institutions toward investors who look for long-term value creation rather than short-term earnings.
- In struggling economies, the additional accumulated regulatory capital would provide the necessary cushion and time frame for institutions to absorb losses and hold or seek more orderly liquidation of assets. This process would, in turn, prevent dramatic declines in sales prices (and, thus, fair value) across other institutions.
- The counter-cyclical declining capital requirements in weak economies would enable financial institutions to operate their core lending businesses rationally, without limiting them to capital requirements better suited to stable economic environments.
- Generally Accepted Accounting Principles would be separated more effectively from the regulatory capital requirements, thereby enabling investors to have the information they need while, at the same time, providing regulators with the tools they need for properly monitoring financial institution safety and soundness.
You can read the entire proposal.