Today's controversies concern the valuation of assets on bank's balance sheets, especially those related to real estate. Bank write-downs around the world already amount to half a trillion dollars and counting. Many banks allege that mark-to-market rules which compel them to value assets according to what they can be sold for on the open market (hence the term "mark-to-market") are worsening their situation. Extremely bearish sentiment is causing these assets to be unfairly undervalued, or so they say. Thus, many banks are pressuring their governments to relax rules pertaining to mark-to-market valuation.
Like most everything else, there is a political economy of accounting. Financial industry lobbying has been behind the European Commission asking the International Accounting Standards Board (IASB) to give in a little on what assets need to be marked to market. The EC has applied pressure on the IASB in the basic form of "well, if you don't give in a little, then we'll create an accounting standards body of our own." Something which has long been advocated is unification of accounting standards worldwide to reduce opportunities for regulatory arbitrage, or that financial institutions would prefer to set up their headquarters in a place where regulations are not so stringent. Doing so would boost paper earnings figures ("the bottom line") and perhaps allow a more gung-ho attitude towards risk.
American politicians have mooted an easing of such rules, although it hasn't gone as far in lobbying terms as the Europeans have now gone to implement these as the Wall Street Journal notes below in allowing some reclassifying of securities to evade having to realistically value certain assets. You may initially think that reducing the amount of write-downs would help European banks. However, it is entirely possible that this accounting sleight of hand will mean that these impaired securities will be kept on bank's balance sheets for a longer period of time, thus prolonging the problem. Resorting to "mark-to-make believe" is not a novel solution during times of crises related to popping asset bubbles, as Kirkegaard and Posen of the Peterson Institute (nee IIE) suggest:
Allowing losses to be covered up will only prolong the credit-crunch, as it lets banks and other companies deny and hide their problems. This is precisely what kept Japan in crisis throughout the 1990s, and what led to the US Savings and Loan crisis in the mid-1980s. In both of these cases and others, removing discipline by regulatory forbearance—having regulators suspend the market-based criteria in hopes the market will turn around—led to accumulation of more bad assets and continuing decline in asset values.To say I am skeptical of the EC's move is putting it mildly. Nevertheless, it appears this political football will be played and played hard with respect to mark-to-market. If it's any consolation, I seriously doubt that Playboy will soon come out with the "Girls of IASB [!]:
Furthermore, should we really believe that there will ever again be a liquid market, let alone higher prices, for many of the mortgage-backed securities that are at the heart of this crisis absent government intervention to restructure these securities? That banks gaining a ‘virtual capital injection' by a redefinition of their losses will suddenly start to buy more of these assets rather than all selling them? That others will buy them at inflated prices where they have not at current discounts?
The problem is not just that US housing prices have fallen, which should have been priced in, but that the risk attributes, opacity, and legal complications inherent in these securities make them illiquid and toxic. Suspending mark-to-market does not change that reality.
European banks could soon find it much easier to avoid write-downs thanks to changes in accounting rules being pushed through by European policy makers. In moves that analysts say could boost earnings but make it harder to discern the financial health of banks, the European Union and international accounting standard-setters are loosening so-called mark-to-market accounting rules, which require banks to value investments at the price they would get if they sold them immediately.
The changes will allow banks to reclassify some assets as long-term investments, a shift that will grant them a great deal more leeway in deciding what those assets are worth -- and how much they have lost in the latest bout of financial turmoil. The new accounting rules are "one of the many weapons being deployed to fix the banking crisis," Belgian Finance Minister Didier Reynders said in an interview.
Analysts say it is difficult to estimate how much banks could reclassify among their hundreds of billions of dollars in loans and other investments. Yet not having to value some assets at the current market price "could have a material impact on earnings," said Morgan Stanley analyst Michael Helsby.
The rule changes touch on an issue that has become highly controversial amid the global financial crisis. Bankers have complained that mark-to-market rules are making their finances look worse than they are by forcing them to value their assets at market prices at a time when markets aren't working. But loosening the rules could allow them to hide serious problems.
The new rules will bring European accounting standards more in line with those in the U.S., where reclassification of assets to and from trading books is permitted in rare circumstances. In Europe, which lacks an overarching regulator like the U.S. Securities and Exchange Commission, banks could have an easier time bending these rules to their advantage, analysts say.
"Given the current weak accounting enforcement in EU countries, any proposal permitting certain exceptions in 'rare' circumstances is open to abuse," wrote J.P. Morgan analyst Sarah Deans in a recent report. Ms. Deans points out that the International Accounting Standards Board, a body that sets standards for more than 100 countries, has indicated that the current financial crisis could be considered a rare circumstance.
The IASB made some changes last week, allowing banks to reclassify assets such as loans and receivables. The IASB said it expedited its decision following requests from EU officials, who wanted to see the measure put in place quickly. EU officials say that by month's end, the IASB changes could be broadened to include complex derivatives, a type of investment on which banks have already suffered tens of billions of dollars in write-downs.
Ms. Deans and other analysts say the reclassifying of assets reduces consistency and transparency of financial statements between banks and among countries, which may ultimately dent investor confidence. That's in part because banks have some flexibility to value assets if they are not marked to market. By assigning unduly high values to assets, banks would simply be postponing losses, rather than alleviating them.