Reason With The Messenger; Don’t Shoot Him: Value Accounting, Risk Management And Financial System Resilience

The U.S. Economic Emergency Act of 2008 allows the SEC to suspend mark-to-market accounting rules. But a blanket suspension would be counter-productive. Crises are times when uncertainty quickly turns to panic. Now is not the time to increase uncertainty by changing accounting standards. This article proposes an alternative: mark-to-funding.

The Economic Emergency Act of 2008 reaffirms the authority of the SEC to suspend fair value accounting. Observers elsewhere support a suspension of this accounting rule. It is a widespread view, especially amongst bankers, that International Financial Reporting Standards (IFRS) on fair value accounting compounded the recent financial crisis.  Application of the IAS 39 rule that governs loan-loss provisions and extends mark-to-market valuation of assets meant that when credit prices fell sharply and asset values were written down, banks were forced to sell assets and pull back credit lines to raise capital, which lowered asset prices further, causing more write downs and more capital losses. The jump in mark-to-market volatility compounded the problem by keeping buyers away. When lower prices do not drag out bargain hunters, but instead, more sellers, liquidity vanishes into what I have called a Liquidity Black Hole.

In the Liquidity Black Hole of 2007/8 credit risk instruments were being priced, not in terms of the probabilities of default, but in terms of they would fetch if they had to be sold tomorrow in a massive clearance sale, to the diminishing number of buyers who do not require credit to purchase the assets and do not care about mark-to-market volatility. Consequently, prices have plummeted far below any measure determined by the risk of default. These prices represent liquidity-risk, not credit-risk. But a blanket suspension of mark-to-market rules would be counter-productive.

Crises are a time when rumours are rife and uncertainty quickly turns to panic. It is not the time to increase uncertainty by changing accounting standards. Moreover, this would work against future crisis avoidance. Financial crashes are not random: they follow booms. Offering forbearance from mark-to-market accounting rules during a crisis, yet using these rules during the preceding boom, would promote excessive lending and leverage in the good times. This asymmetry in the application of rules could contribute to more frequent and severe crashes. There is room for a principled revision to the application of mark-to-market rules, not a revision based on relying on the messenger’s every last word in good times and shooting him when things turn bad.

There is another important issue that points the way to resolution of this issue. Under Basle I, the mechanism by which falling prices of assets lead to further declines in the price of assets was driven in large part by value accounting of assets. Under Basle II, market prices enter into both valuation and risk assessment. The very philosophy of Basle II – risk sensitivity – is about incorporating market prices into the assessment and response to risk. It should be no surprise that putting market prices at the heart of the system whose purpose is to avoid market failure will lead to systemic collapse. But the point is that simply changing the value accounting, but continuing to use market prices and their proxies such as credit ratings in assessment of the riskiness of assets will not pull us out of the liquidity black hole.

From a risk management perspective, the problem with the current value accounting rules is that the focus is on the asset: its perceived liquidity and the intention of the asset holder to hold it to maturity or to trade it. We have seen how asset liquidity and holder intentions can change rapidly in a crisis leading to an increasingly artificial view of value and solvency. We should instead focus on the funding liquidity of the asset. Where assets are funded with short-term liabilities, then whatever the perceived liquidity or intentions of the asset owners, it is appropriate to mark the value of that asset to market in case funding dries up and the assets need to be sold tomorrow. But where assets are funded with long-term liabilities or set against long-term liabilities, as is typically the case with a young pension fund, then marking asset values to market is not appropriate and can lead to an artificial view of risk and investment decisions based on a risk that is not important to the holder.

The valuation “window” and the duration of risk management should be linked directly to the maturity of funding. The scope for banks to switch away from mark-to-market accounting under my proposal will be less than they are currently employing by re-classifying assets from trading to hold to maturity. But the scope this presents would be more credible for being less artificial. Moreover, this proposal which I may call “mark-to-funding” would provide scope for banks and other institutions to create (risk absorbing) pools of capital – funded with long-term liabilities – that could buy assets that are at a distressed price today, without being held back by short-term price volatility.

To date crisis management efforts have been focused on trying to reduce the selling of assets: getting buyers back to the market place would also help.

Editors’ Note:This column is a precis of a presentation given by the author and hosted by the Banque de France on October 12 in Washington at the annual IMF/World Bank meetings.