Monday, January 05, 2009

French Central Bank Head Sets Out Broad Principles for Regulatory Reform, Including Fair Value Accounting

In a series of speeches at the end of 2008, French Central Bank President Christian Noyer set forth a bold plan for financial regulation reform involving three levels of regulation, ranging from most restrictive to least restrictive. He also said that fair value accounting standards must be made globally consistent and fit into the gradation model.

An overarching principle of the new regulatory framework is that all market participants and financial institutions that have an impact on financial stability must be regulated, including hedge funds, credit rating agencies, and large financial institutions. Macro prudential regulation will also be needed in light of the failure of regulators to either assess or prevent risk management failures that destabilized the entire financial system.

The central banker recommended a tripartite regulatory framework that recognizes that market participants have very different functions and pursue different strategies. Since this diversity is crucial to the markets, he reasoned, a one-size-fits-all model of regulation is not appropriate.

He proposed three levels of regulation. The first level would take the form of mandatory registration and the commitment to comply with a code of best practices. The second and more restrictive level would include disclosure obligations with regard to activities and accounts, in addition to the mandatory registration and the compliance with best practices. Hedge funds and, more generally, institutions pursuing strategies essentially based on leverage or risk-taking, would have to meet such requirements. Finally, the last level would involve more restrictive regulations with regard to activities and risk-taking, as well as closer oversight. All three levels of regulation must be infused with sound and efficient risk management.

This gradation model could also be applied to financial accounting standards, he continued, particularly the fair value accounting standard. Trying to measure all assets and liabilities at fair value has some drawbacks, he said, and even entails some risk. Moreover, the impact of applying the fair value accounting standard goes beyond accounting policy and affects overall financial stability. Indeed, he emphasized that in many respects the current crisis is about valuation.

Uncertainty surrounding the value of complex and illiquid financial instruments undermined confidence in the markets, increased uncertainty about counterparty risk and led to contagion across asset classes. The crisis has highlighted the fact that the valuation of financial instruments is not only a question of accounting. It also raises issues of risk measurement and management by financial institutions, prudential issues via the definition of capital requirements and, more widely, financial stability issues.

The broad aim of fair value accounting is to enable investors, financial system participants, and regulators to better understand the risk profile of securities in order to better assess their position. In order to achieve this, financial statements must, in the case of instruments for which it is economically relevant, be sensitive to price signals from markets, which reflect transaction values.

There is also a link between fair value accounting and risk management. For example, because this rule makes it possible to record substantial income flows during cyclical upswings, it has contributed to greater risk-taking by some institutions in order to maintain these income flows year after year. In a more general way, the extension of the scope of application of fair value accounting has very probably, during cyclical upswings, also contributed to assets being accounted for at market value whereas the intention of market participants to manage these assets on a fair value basis was not clear.

The financial industry accepts that there will inevitably be uncertainty surrounding the valuation of illiquid securities, said the official, and also recognizes the limitations of the mathematical models used to value these unmarketable securities. In his view, these two factors of price volatility over the financial cycle and the limits of quantitative techniques highlight a number of divergences between internal risk management and fair value accounting. More generally, accounting rules that give the value of a company or activity at a given moment do not always allow the forward-looking valuation of financial instruments or sound risk management practices. Yet these aspects are important for regulators. Conversely, choices in terms of prudential regulation can have an impact on financial stability when they interact with certain accounting rules.

The recent G-20 summit called on standard setters to develop a single high-quality fair value accounting standard that would enhance the required disclosure of complex securities, noted the central banker, and the heads of state linked this goal to ensuring overall financial stability. He said that the fair value accounting standard should not be weakened because it is a key component of accurate and fully transparent financial statements, which in turn are the bedrock of financial activity. But the accounting standard should be reformed to fully reflect the reality of financial activities.