The financial crisis has exposed a number of flaws in the worldwide financial system. One obvious flaw is mark-to-market accounting as it is applied to banks and other financial services firms.
If there was ever any doubt, it should now be clear that a strict and immediate application of mark-to-market accounting to the entire balance sheets of financial services firms exacerbates crises, limiting firms' abilities to create and use financial shock absorbers and destabilizing the firms through extreme revaluation requirements just when more stability is needed.
For decades and decades regulators used regulatory accounting principles — "RAP," not GAAP — in recognition that financial services firms are different. Fundamentally, this is because some important instruments are inherently hard to value or given to a considerable amount of volatility and subjectivity, and because as a matter of public policy regulators rightly abhor the systemic instability a sudden lack of confidence in the financial system creates.
A rapid revaluation in financial assets can lead to catastrophic results not just for one institution, or even several, but for the whole economy through a "financial contagion." A run on a bank impacts not only the bank, its shareholders, and employees, but also savers and borrowers in the relevant community. And a systemic event — an exodus from a financial product or sector — can lead to enormous losses and economic stagnation outside as well as inside the financial system. The panic of 1907, the Great Depression, and the credit crunch of the early 1990s are but three examples.
The destructive volatility in the price of financial assets is not just the result of leverage, though leverage magnifies the problem; nor is it just the result of deliberate mispricing, though that can sometimes occur. It largely stems from the fact that financial values can be determined by emotion as much as logic, particularly in the short term. This fact is not something that can simply be willed away by accounting standard setters; it is a reflection of the human condition.
Public interest requires that financial regulators be concerned with maintaining a safe and sound system that supports the U.S. economy, as well as making sure firms provide accurate statements.
Historically, regulators have achieved both objectives by putting a governor on these emotional and potentially damaging swings. They encouraged banks to build reserves, so they could absorb losses caused by sudden, unanticipated increases in market volatility. These reserves relied heavily on the banker's judgment and included a great deal of flexibility to reserve against unanticipated losses in the portfolio as a whole.
Bank regulators also allowed a bank to hold assets at book value, particularly those the bank did not intend to trade. These at-book valuations were not upset easily, even when a bank was forced to sell certain assets out of this portfolio.
Over the past decade financial firms have been pressured to trim reserves, ostensibly to prevent managing of earnings. Accounting theorists argue that allowing banks to dampen the volatility of their balance sheets makes their published statements less accurate and less transparent to investors. With similar logic, the ability to maintain a held to maturity account where assets are accounted for at book value has become ever more difficult.
Over the last several months this ideological purity in terms of valuation has contributed greatly to massive pro-cyclical, self-reinforcing, and self-extending writedowns. These writedowns are forcing banks and other institutions to raise capital at the worst possible times, at best shredding shareholders and threatening the viability of institutions, and at worst causing a credit shutdown that might have been avoided.
As if this were not enough, the Financial Accounting Standards Board is expected to propose changes soon in FAS 140 that promise to make shedding risk through asset securitizations much more difficult. A swift application of these changes could further deepen the financial crisis.
We must get out of the accounting corner in which we have painted the financial services system. For starters, I would propose the following:
- Give banks and other financial firms a great deal more flexibility in setting reserves, encouraging the use of judgment and not merely models. For example, let them set aside a portion of the general reserve to cover losses from unanticipated increases in asset price volatility. That amount needs to be disclosed, but it should reflect the banker's best judgment and should not have to be based on a formulaic exercise.
- Give banks and other financial firms the right to phase in any market-driven revaluation of assets and liabilities over several quarters, so it takes into account changes over a period, as opposed to a change at one point in time.
- Once again, give a financial services company's primary regulator — not the FASB — the ultimate say over its accounting, even where it differs from GAAP. In this regard, financial services regulators should be admonished to work together to set rules, perhaps thorough the Federal Financial Institutions Examination Council, and take into account the accounting board's views.
Yes, I would go back to RAP for financial services firms.Common sense tells us banks need to set aside reserves to withstand plausible losses, even if we do not expect them to occur. And the futility of attempting to establish valuations for financial instruments in highly volatile markets should now be obvious to all. Under such conditions, values are more a matter of the whim of the moment than a dispassionate analytical exercise.
After all, accounting is a manmade attempt to provide an accurate representation of financial reality. Like every human endeavor, it is only an approximation of that reality, not a universal truth.
Sound regulatory policy demands that we strike a balance between reverence for accounting consistency and the realities of maintaining a stable financial system. The current mark-to-market rules are not helping us strike an appropriate balance.
