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The merits and demerits of mark to market or fair value accounting since its birth have triggered heated and aggressive debates among its opponents and proponents. On one hand the proponents of this accounting system do not stop advocating its merits and its far reaching transparency effects on the financial system while on the other hand the opponents keep on criticizing this concept and point out its unwanted and harm full effects on the financial system. One of the hottest issues which is widely criticized by the opponents of this accounting system is the interaction of fair value accounting with prudential capital regulations which are imposed on banks by their respective regulators in order to ensure their solvency. There are many empirical studies that suggest the reasons for market price distortions for example market illiquidity or due to limits to arbitrage (Shelifer and Vishny,1992,1997). The critics argue that in times of market distortions writing down the assets to the distorted prices can cause regulatory capital problems for the reporting financial institution and in order to comply with the capital requirements the firm may have to sale its assets at fire sale prices which may result in setting a downward spiral in the asset prices.
Cifuentes et al., 2005 argues that prudential regulations such as the minimum capital requirements when used in combination with the mark to market accounting rules can result in a downward spiral in the asset prices and can become a significant source of systematic risk in the financial system. He argues that a shock that results in depressing the market value of an asset held by a financial institution, which is accounted for using mark to market accounting rules in its accounts, can result in forced disposal of its additional assets. In other words as a result of this shock the firm will have to write off the value of this asset to its current depressed market value and recognize the loss, which will in turn lead to depletion of its regulatory capital and in order to escape the violation of the minimum capital requirements the firm will have to sell its additional assets and in a situation where the ability of the market to absorb such sales is less than perfect, these additional sales will result in further fall in prices and hence setting a downward spiral. In addition if these fire sale prices become relevant marks for other financial institutions then these institutions may also face similar regulatory capital problems which are otherwise sound.
Heaton et al.,2009 studies the real macroeconomic consequences of the interaction between the accounting rules with the regulatory capital requirements. In order to study this interaction he develops a general equilibrium model and argues that even in a situation where market prices always reflect the fundamental values of an asset, the interaction of fair value accounting rules with the capital requirements can result in inefficiencies that do not exist when the capital is being measured by adjusted book values. He argues that the incentive for a bank to take risk depends on its capital and on the risks associated with its assets and liabilities. Factors that affect market prices such as price of aggregate risk may have little effect on the incentive for a bank to take risk. Therefore a constant market value based minimum capital requirement is inefficient and can lead to high rate of bank reorganizations or contraction in lending in downturns. One interesting solution he proposes is that instead of abandoning fair value accounting and the other benefits associated with it, the problems can be eliminated by redefining capital requirements to be pro-cyclical.
Allen and Carletti;2006 argues that in a situation where mark-to-market accounting rule is in practice, the volatility of the asset prices directly affect the value of the bank's assets. In times of financial distress marking assets to market can lead to contagion and force the banks going insolvent even though they were fully able to cover their obligations if they were allowed to continue their operations till the time the assets reach their maturity.
The problem of contagion can also occur when the management of a bank is focused on short term accounting numbers in order to increase its reporting earnings. This may be due to the reason that the compensation such as bonuses are based on the firm's reported earnings. In this type of situation the management of the firm may find an incentive to sell comparatively less liquid assets at a price below its fundamental value in order to pre-empt the anticipated sales of the other market participants (Plantin et al 2008). By doing so the management can avoid marking assets to a price even below its market price but creates contagion problems for other banks.
The arguments discussed above show potential problems with the pure mark to market accounting, but in reality the accounting rules do not stipulate pure mark to market accounting. Therefore now in the next section this paper will try to investigate as to what extent the fair value accounting rules in practice contributed to the financial crisis.
Background Of Accounting Practices In The United States
The US Securities and Exchange Commission (SEC) with the mission to protect investors, maintain fair, orderly and efficient markets requires the publically traded companies (on the US Stock Exchange) to prepare and file quarterly financial statements which include balance sheet and income statements. The financial statements are prepared in accordance with the Generally Accepted Accounting Principles (GAAP) and subsequently enforced by the auditors, the SEC and the private securities litigation. A privately run organization known as the Financial Accounting Standards Board (FASB) has been mandated the task of establishing financial reporting standards by the SEC.
The Generally Accepted Accounting Principles come up with the objective of facilitating the financial transactions and the contracts in the economy. The financial statements of a firm provide its stakeholders such as investors, regulators, creditors with the standardized information which they use for their respective needs. For a financial statement to be useful it is important the numbers contained in it should be relevant and reliable, however there is sometimes a conflict between relevance and reliability. There can be a case where a figure stated in financial statement is very reliable but at the same time this figure may not be relevant and vice versa. In addition the question as to what is relevant also sometimes differs across the users of the financial statement. So in nutshell one can suggest that the accounting rules often face a tradeoff between relevance and reliability. Mostly, while enforcing the regulations the bank regulators start with the bank's financial statements prepared in accordance with the GAAP to measure the bank capital, however sometimes they set up their own rules instead of following GAAP. An example from SEC(2008) is reproduced: "although unrealized gains and losses for AFS(Available for Sale) debt securities are included in U.S GAAP-based equity (as part of accumulated Other Comprehensive Income), these unrealized gains and losses generally do not impact regulatory capital. Losses that are realized by a bank, either by sale of the debt security or determination that the decline in the fair value of the debt security is other-than temporary, are reflected in regulatory capital".
FAS-157 Fair Value Measurements:
The "Statement of Financial Accounting Standards No.157" is a statement issued by the Financial Accounting Standards Board in the year 2006. The statement defines fair values, establishes a mechanism for measuring fair values in the Generally Accepted Accounting Principles (GAAP) and expands disclosures about the fair value measurements.(FAS-157)
Definition of Fair Value:
The Generally Accepted Accounting Definition of "Fair Value" is defined in the FAS 157 as "the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date".
This fair value definition gives an ideal "exit value" idea in which firms exit the positions they hold at a given date through orderly transactions with the market participants at the measurement date, not through fire sales.
The term "At the measurement date" in the definition means that fair value of the asset or liability held by a firm should show the conditions that are present at the balance sheet date. For instance if at the balance sheet date the market liquidity is at unusual levels, the fair values should reflect the same condition.
The term "orderly transaction" means that the transaction should not be a forced one and should not be a one which takes place hurriedly. The rule expects the entity to hold a usual customary market survey to identify potential buyers of assets and assumers of liabilities. On the other hand the potential buyers of assets and assumers of liabilities are also expected to hold usual market survey.
"Market participants" are the people who are fully informed, un-related and able to transact. Fully informed parties are not only those people who are sophisticated and aware of the market conditions but in addition they should have ascertained as best possible the fair values of the positions they are willing to transact.
The concept of fair value measurement aims the firms to estimate as best as possible the prices of the positions they currently hold at which they would be sold in an orderly transaction based on the prevailing information and market conditions and recognize gains and losses in their financial statements. In order to fulfill this task the firms must include the present information about future cash flows and the prevailing risk adjusted discount rates into their fair value measurements. In a situation where market prices for the same or similar positions are available, FAS 157 normally requires the firms to use these prices while estimating the fair values. The reason behind this requirement is that market prices should show all publically available information regarding the future cash flows and the current risk adjusted discount rates. In a situation where fair value is estimated using unadjusted or adjusted market prices, it is also known as the mark to market value. When the market prices for the same or similar assets are un-available the firms should estimate the fair values using different valuations models based on observable market inputs such as interest rates and yield curves (on commonly quoted intervals) when they are available. If in case observable market inputs are not available the rules allow firms to use unobservable inputs based on their own assumptions.
Hierarchy of Fair Value Measurement Inputs
The FAS-157 establishes a three level hierarchy of inputs for the measurement of fair values starting form the most reliable to least reliable. The most reliable one being the level-1 inputs which are the unadjusted quoted market prices (from transactions or dealers) in active markets for identical products in an orderly transaction. The rule clearly states that the orderly transaction is not a forced liquidation or distress sale. With some exceptional cases, FAS-157 stresses the use of level-1 inputs whenever they are available for the measurement of fair values.
In the absence of level-1 inputs the rule permits the firms to use "level 2" inputs for the measurement of the fair value. In level 2 hierarchy, models are used to determine the value of an asset or a liability. This approach is also sometimes called as "marking to model" approach. FAS-157 requires the reporting entity to use models based on observable inputs that include quoted prices for similar assets or other relevant market data such as interest rate yield curves or spreads between related interest rates.
The unobservable inputs used to derive the value of an asset or liability, are classified as the level 3 inputs. These inputs show the reporting entity's own assumptions about the assumptions, the market participants would use in pricing the asset or liability. In other words level 3 inputs are typically model assumptions and they can be used in a situation where observable inputs are not available.
It is worth mentioning here that the concept of fair value was in existence prior to the issuance of FAS-157. A number of other U.S accounting standards refer to fair value while measuring the values of assets and liabilities, for example FAS 115 which was implemented in the year 1994. This standard requires both trading and available for sale securities to be recorded at fair value in the entity's balance sheet. Therefore even some rules of FAS-157 are suspended, the practice of fair value accounting will not going to end.
Fair Value Accounting Versus Historical Cost Accounting
Historical Cost Accounting is the main alternative to Fair-Value Accounting. Under this framework the values of the assets are stated at historical cost i.e. the price paid to buy these assets (fair value of the asset at the time of its purchase). Under this framework the values of the assets are adjusted for amortization and impairments but no adjustments are made for the increase in asset values. The assets held by a firm are subject to impairment when the fair value of the assets falls below its amortized cost. In a situation where the value of an asset declines and there is no restriction on impairment, both fair value and historical cost accounting are conceptually same but in practice the impairment test is different across the assets.
The fair value accounting provides more reliable information and leaves a little room for manipulation whenever level-1 inputs are being used i.e. prices of identical assets from active markets. In a situation where level-2 inputs are being used the management gets more discretion in the valuation of assets. Level-3 inputs provide much more discretion while valuation of the assets held by the firm as no observable inputs are being used. One of the characteristics of historical cost accounting is that it leaves a very little room for manipulation but the criticism on this framework is that with the passage of time the historical cost information becomes less relevant. In addition one of the drawbacks of historical cost accounting is that in order to recognize gains the banks may find incentive to indulge in selling and repurchasing of assets which have appreciated in value and can be traded into liquid markets.
Accounting Rules Relevant To Financial Assets Held By Banks
The Generally Accepted Accounting Principles require different measurement attributes to be used for accounting of financial instruments. This approach is also sometimes called as the mixed-attribute model. The table below shows the asset weighted averages for key assets of U.S banks (reported values as a fraction of total Assets) for the year 2004 to the year 2006.
In the table above the large bank holding companies include banks whose assets are greater than $100 billion and this sample includes on average 27 banks. "Small bank holding companies" category includes a sample of 412 banks with assets valuing between $1 billion and $100 billion. The category of large investment banks includes Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers and Bear Sterns. Repo Agreements refer to the federal funds sold and securities borrowed or securities purchased under the agreements to resell. The category "Collateralized Agreements" refers to securities borrowed and securities purchased with the agreement to resell. The "Receivables" are from brokers, dealers, counterparties, customers and in few cases consumer loans. (Laux and Leuz 2010).
As we can see from the table that "Loans and Leases" are the most important part of both Large and Small Bank Holding Companies' assets. For Small Bank Holding Companies this category comprises of 47.28% of their total assets and for Large Bank Holding Companies it comprises of 61.67 of its total asset. In order to account for this category the management can classify these assets either as "Held for Sale" or "Held For Investment". If these assets are classified as "Held For Sale" then they are accounted for at lower of historical cost or fair value under FAS-65, "Accounting for Certain Mortgage Banking Activities (mortgage) and SOP-01-6, "Accounting For Certain Entities. However these type of Loans and Leases are very small. (Laux and Leuz 2010, Ryan 2008).
The accounting treatment for "Held-for-Investment" loans and leases is based on historical-cost accounting. These assets are reported at their amortized cost i.e. principle amount outstanding adjusted for amortization and are also subject to impairment testing. For the impairment of loan FAS-114 states "A loan is impaired when, based on current information and events, it is probable that a creditor will be unable to collect all the amounts due according to the contractual terms of the loan agreement." In the case of impairment the loan amount is written down to the present value of expected future cash flows. The fair value estimate of these type of assets is also to be disclosed in the notes to the reporting entity's financial statements. (FAS:107-Disclosures About Fair Value Instruments).
The very first category in this table is of "Trading Assets". As we can see from the table this category is important for Investment Banks and the Large Bank Holding Companies, while this category is not of that importance for the smaller Bank Holding Companies as it is just 0.71% of its total assets. FAS-115 defines trading assets as "Securities that are bought and held principally for the purpose of selling them in near term (thus held for a short period of time)". FAS-115 requires trading assets to be measured at fair value in the financial statements of the reporting entity and any unrealized gains and losses shall be incorporated in the earnings.
Now if we look at the second asset category of the Bank Holding Companies i.e. "Other Securities" which accounts for 14.56% and 17.79% for Large and Small Bank Holding Companies respectively. Under FAS-115 these securities can be classified as "held to maturity" or "available for sale". As we can see from the table the category "Other Securities" is further broke up into "Available for Sale" and "Held To Maturity". For both small and large bank holding companies the percentage of "Held to Maturity" is very small whereas "Available for Sale" securities comprise of 14.56% and 17.79% for Large and Small Bank Holding Companies respectively. FAS-115 requires securities that are classified as available for sale to be reported at fair value. Any unrealized gain or loss resulting from the change in fair value that is deemed to be as temporary is not recognized in the income statement and it is reported separately in "accumulated other comprehensive income" as part of the shareholders' equity, but in a situation where the changes in the fair value are believed to be "other than temporary" then any gain or loss arising is reported in the income statement.
According to FAS-115 investments in debt securities shall be classified as held to maturity only if the reporting entity has the positive intent and ability to hold these securities till their maturity time. "Held to Maturity" securities are reported in the balance sheet at their historical cost and adjustments are made for amortization. These securities are subject to impairment testing (other than temporary) and the reporting entity has to disclose their fair value in the notes to its financial statements.
FAS-159 "The Fair Value Option for Financial Assets and Financial Liabilities" permits the entities to chose to measure financial instruments and certain other items at fair value. The goal behind this option is to improve financial reporting by providing entities with the opportunity to mitigate earnings volatility caused by measuring assets and liabilities differently. Securities for which banks chose the fair value option are treated like securities while the fraction of non trading securities that the banks reported under fair value option is negligible in 2007 and 2008.(Laux and Leuz 2010)
As we can see from the table "Collateralized Agreements" comprise a big chunk of the assets of the large investment banks. As mentioned earlier these agreements consist of securities that are purchased and securities borrowed with the agreement to resell. Bank Holding Companies also have Repo Agreements. Both Collateralized and Repo Agreements, due to their nature are reported at amounts near fair value, although technically they are often reported at historical cost. (Laux and Leuz 2010)
Therefore the crux of all the discussion above is that in case of large bank holding companies, around 36 of their total assets are reported at or near to fair value and the fair value of another 50% of their total assets is disclosed in the notes to their financial statements. Whereas for investment banks the percentage of assets reported at fair value is higher due to the heavy chunk of trading assets and Collateralized Agreements.
Among the assets reported at fair value the use of Level-1 inputs (pure mark to market) and level-3 inputs was quite smaller. Most of the assets were value using Leve-2 inputs.(Laux and Leuz 2010). This finding brings us to the conclusion that while measuring the fair value of the assets the banks did not use mark to the market accounting in its pure form.