French Central Bank Official Views Fair Value Accounting as Tool to Fight Procyclicality

Noting that there is no reasonable or practical alternative to fair value accounting for tradable securities, the Deputy Governor of the Bank of France believes that accounting standards, including fair value standards, may yet be used as a tool to address procyclicality and pre-empt the build up of imbalances in the financial system. In recent remarks, Governor Jean-Pierre Landau said that regulatory concern on fair value accounting’s impact should focus on procyclicality that originates and amplifies inside the financial system and not the type caused by cyclical evolutions in the real economy.

In its proposed reforms of the US financial regulatory system, the Obama Administration noted that the interpretation and application of fair value accounting standards raised significant procyclical concerns.; and that earlier loss recognition could have reduced procyclicality. The Administration called for a review of the fair value accounting rules.

Procyclicality refers to the tendency of financial variables to fluctuate around a trend during the economic cycle. Procyclicality of capital occurs when financial institutions are profitable and their strong capital base allows them to take larger positions in the markets. This mechanism has been amplified by mark-to-market accounting. In a mark- to-market environment, an increase in asset prices quickly translates into stronger capital for financial institutions. In turn, this triggers additional demand for assets and a further increase in their prices. Procyclicality in leverage is more subtle. It has been shown that financial institutions' balance sheets expand and contract with the economic cycle. Risk management practices hardwired to valuations strongly amplify fluctuations in leverage and may lead to fire sales and one sided markets.

There is currently no consensus on whether accounting standards, particularly mark-to-market rules, contributed procyclicality to the financial crisis. According to one view, the application of fair value accounting to financial instruments is neutral; and any procyclicality in financial variables faithfully reflects reality. An opposite view holds that accounting creates incentives, influences behavior and, therefore, fair accounting rules have a significant impact on the dynamics of financial systems.

While not officially taking sides in the debate, the central banker did note that accounting methodologies played a central role in the crisis. The instant recognition of profits led to a disconnection in time between measuring the return on an asset and recognizing the risk; he said, which in turn created a powerful incentive to take risk and strongly amplified the credit cycle.

While it will always be difficult, when looking at revenues drawn from a financial investment to distinguish excess return from additional risk taking, said the central banker, financial reporting could be conceived in such a way that this distinction is prudently introduced. For example, he noted that the application of fair value accounting to a security does not mean that any single valuation gain or loss should instantly be recognized as a profit or loss and financially treated as such.

It is possible to delink valuation from income and profit recognition. Some disconnection between the valuation process, which should remain anchored on market prices, and income and profit recognition would have to be introduced, he reasoned, if only to account for risks which are out there but have not yet materialized.

Dynamic provisioning is one technique for doing so, he said, especially when risks are closely related to the economic cycle. Valuation reserves may also be used when complexity or illiquidity creates additional risk linked to valuation. If these adjustments are rule based and made in a fully transparent process, he added, they would not reduce either the quantity or quality of information available to investors as to the real health of financial institutions.

Another method would be for the regulatory system to force the pricing of risk in all its dimensions. There is a clear analogy with tax theory, he said, in which internalizing the risk eliminates market failures. This approach would be best implemented to liquidity risk linked to maturity transformation. He noted that a number of jurisdictions are considering the imposition of quantitative liquidity ratios on financial institutions. However, he believes that mandatory liquidity ratios may not protect the system against an aggregate liquidity shock, when the demand for liquidity becomes infinite and any buffer proves insufficient.

More broadly, Governor Landau emphasized that procycality forces were at work over a longer time frame than accounting valuations of illiquid securities. During the first phase of the crisis, the short term view of procyclicality may have looked as if mark-to-market accounting, together with highly illiquid markets, generated downward spirals in asset prices and created excessive losses, with no relation to real underlying economic reality. However, it now seems that the disproportion between losses at financial institutions and movements in underlying asset prices can almost fully be accounted for by the extraordinary degree of leverage which accumulated in the financial system over the last decade. Procylicality was at work, he acknowledged, but on a much longer time horizon, and during the upward phase of the credit cycle.

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