By James Hamilton, J.D., LL.M.
UK Financial Services Authority Chair Adair Turner has set out a broad plan for overhauling financial regulation that envisions a systemic risk macro prudential regulator and increased reporting requirements for unregulated financial institutions such as hedge funds. The Turner plan also wrestles with the conundrum of fair value mark-to-market accounting. It is a conundrum because, in normal times, there are significant merits to this accounting approach when viewed from the perspective of an investor seeking accurate information on the value of a security. But in a financial crisis, the application of mark-to-market can feed procyclicality
If a security has a clearly defined market value, noted the Turner report, this is indeed the best indicator of what the shareholders indirectly own at the balance sheet date. And the evidence of the crisis suggests that the financial institutions which most rigorously applied mark-to-market approaches, identifying rapidly the impact of falling prices, performed best since they exited problem asset areas faster and at lower eventual cost.
But from the point of view of regulators, and of systemic financial risk, mark-to-market has serious disadvantages because it can fuel systemic procyclicality. The report observed that the mark-to-market approach means that irrational exuberance in asset prices can feed through to high published profits and perhaps bonuses, encouraging more irrational exuberance in a self-reinforcing fashion. When markets turn down, it can equally drive irrational despair. And, at the systemic level, the idea that values are realizable because they are observable in the market at a point in time is illusory.
If all market participants attempt simultaneously to liquidate positions, reasoned the UK report, markets which were previously liquid will become in illiquid, and realizable values may be significantly lower than the published accounts suggest. Thus, the application of fair value mark-to-market accounting played a significant role in driving the unsustainable upswing in credit security values in the years running up to 2007; and exacerbated the downswing.
This then is the essential challenge of the fair value accounting regime: it makes sense in stable conditions; but is not optimal when viewed from a regulatory, systemic and macro-prudential viewpoint.
The report states, however, that it is possible to devise an approach which can meet both requirements. The key features of this new regime would be using existing accounting rules to determine specific profit and loss, including derivative positions, which would continue to reflect fair value mark-to-market approaches, while augmenting these rules with the creation of a non-distributable Economic Cycle Reserve, which would set aside profit in good years to anticipate losses likely to arise in future. As with a regulatory capital buffer, there are two ways by which the size of this reserve could be determined. It could either be proposed by management, after extensive consultation with boards and risk committees, and approved by regulators or by a pre-determined formula.
In a discussion paper accompanying the report, the FSA emphasized that, at the current time, for both conceptual and practical reasons, fair value accounting should continue to be used for derivatives and for instruments held for trading purposes. In both cases, a mark-to-market approach is the correct one. For those assets held for the longer term the cost less impairment approach should be applied.