Fair Value Accounting

Key Issues Arising from the Financial Crisis

E. Menicucci

• Publisher: Palgrave Pivot
• Year: 2014
• ISBN:
  9781137448262
• Topic: Business
• Subtopic: International Business
• Index: Business

The 2008 financial crisis has turned a spotlight on the role of financial reporting in periods of economic downturn. In analysing the financial crisis, many commentators have attributed blame to fair value accounting (FVA) because of the pro-cyclical effect it potentially introduces in banks' financial statements.This book discusses how FVA affects financial reporting during a financial crisis. It provides an in-depth analysis of the key benefits and negatives of FVA, and discusses the controversial practice of trade-offs with historical cost accounting (HCA). It provides an overview of the principles and applications of FVA, and explains its impact on banks' financial statements. Investigating the effect of FVA on the volatility of earnings and regulatory capital in European banks, the book asks whether incremental volatility is indeed reflected in bank share prices. It examines empirical evidence to quantify the role that FVA may have played in times of stress in the banking sector, both in Europe and elsewhere.Fair Value Accounting explores the criticism FVA has received despite its perceived merits, and summarizes the various opposing views of parties in this major policy debate, which has involved banking and accounting regulators from across the globe.

1

Financial Crisis and Fair Value Accounting (FVA)

Abstract: The global financial crisis (GFC) has drawn attention to the role of financial reporting and to the implications for accounting in times of financial downturn. Many critics attribute blame to the fair value measurement approach, especially for reporting financial instruments in the balance sheets of financial institutions. The focus of the intense debate on fair value accounting (FVA) is whether it is or is not the cause of the financial crisis and whether its pro-cyclical effects towards the economy have played an active role in the financial crisis. The application of FVA would have caused a pro-cyclical consequence on firm’s balance sheet and on profitability, intensifying downturns and decreasing financial stability during the financial crisis.

Menicucci, Elisa. Fair Value Accounting: Key Issues Arising from the Financial Crisis. Basingstoke: Palgrave Macmillan, 2015. DOI: 10.1057/9781137448262.0003.

1.1Introduction

Historically, there have been many arguments in the area of corporate financial reporting, and critics judged especially its performance in providing information to value firms. Financial reporting is of great importance to investors and to other financial market participants in allocating resources. The confidence of all these users (e.g., stakeholders) in transparency and reliability of financial reporting is critical to global financial stability and economic growth. In fact, financial reporting plays a central role in the financial system by trying to deliver fair, transparent and relevant information about the economic performance and the state of businesses.¹

In particular, the objective of financial reporting is to provide information that is useful to present and potential investors and creditors in making investments and credit decisions. As is well known, financial reporting achieves two important functions in market-based economies in this regard. First, financial reports reduce information asymmetry (Bischof et al., 2010) and permit capital providers to value firms, thereby ensuring the transparency necessary for capital markets to operate efficiently (the evaluation role of accounting information). Second, financial reports allow external capital suppliers to display the performance of management (the stewardship role of accounting information).²

Effective financial reporting depends on high quality accounting standards as well as their reliable and faithful application, independent audit and rigorous enforcement. Accounting standards try to attain a consistent and significant assessment of the financial condition of a firm, and the entire accounting profession is responsible for providing the information needed to stakeholders to decide correctly about their investments. Of course, accounting standard setters have always strained to fulfil these goals, and they continuously try to keep standards up to date with the ever-developing markets to encourage the diffusion of high quality information.

The global financial crisis of 2008 (GFC) has drawn attention to the role of financial reporting and to the significant implications for accounting in periods of financial downturn (Pinnuck, 2012), both for practice and for the research community. This financial crisis of unusual size and negative consequences represents a real concern among academics, regulators, and standard setters, and more generally, in societies all over the world. In the areas of financial reporting, auditing and management accounting, the financial crisis raised significant concerns based on several problems and failures. More than that, in the academic and research community, the financial crisis has also highlighted issues that require serious research attention.

In analyzing the GFC, in fact, many critics attribute blame to financial reporting, especially to the fair value measurement approach for reporting financial instruments in the balance sheets of financial institutions. Thus, fair value accounting (further also FVA) is already being fiercely debated, involving not only national accounting regulators but also the ever more concerned International Accounting Standards Board (IASB). The use of FVA has received a growing attention rarely perceived in the history of accounting practice, and one of the driving forces is the belief (endorsed by some) that FVA originated and intensified the 2007 credit crisis (then turned up in the GFC of 2008).

In effect, in the long series of financial crises, the most recent one is the first of exceptional magnitude and large consequences in which the accounting systems in force have encompassed a fair value approach on a worldwide scale. The extent of this recent crisis requires a severe analysis to determine whether the introduction of the new accounting framework just corresponds with the crisis or is a cause of it. This makes the study of FVA extremely relevant, and the use of it has gained much more impulse and traction.

The application of FVA may have a number of different impacts. On one hand, market price changes affect financial statement faster, thus adding to volatility. On the other hand, through the quick reporting and disclosure of risks, FVA helps to increase transparency. The last is a critical matter actually because greater transparency is surely a constant key objective pursued by regulators and policymakers since the beginning of the financial crisis.

This book analyses some of the particular links that can be drawn between FVA and the financial crisis. FVA is neither guilty for the crisis, nor it is merely a measurement system that reports asset values without having economic effects of its own. In this work, we attempt to make sense of the current fair value debate, and we discuss whether many of the debated arguments support further scrutiny. After briefly introducing the concept of fair value into the background of financial reporting at the international level, our investigation focuses on the origin of the relationship between FVA and the financial crisis.

Most importantly, we clarify some of the underlying arguments, merits and challenges posed by the fair value approach, and we examine also what the fair value model attempts to achieve. This insight is helpful to better appreciate some of the issues discussed in the debate on the role played by FVA within the financial crisis. To that end, this book intends to increase awareness of the effects of the application of FVA during a financial crisis and their impacts on financial stability in such a context.

1.2Background information about the financial crisis

The end of 2008 and the beginning of 2009 were characterized by a historical event: the international economy was affected by a severe crisis, which was amplified by a dangerous collapse of developed financial markets. The United States was the epicenter of the global turmoil, which highlighted a number of challenges for central bankers, supervisors and global regulators (Allen and Faff, 2012).

At first, the crisis revealed very traditional features. Financial institutions had made loans using poor quality standards, and then these bad loans were recycled in a very complex and extended chain of securitization (Martin, 2009) whose intermediaries were not able, or sometimes not willing, to evaluate the underlying risks (Matherat, 2008).

This credit crisis appeared in 2007 and caused the collapse or sale of many prestigious financial institutions³ and the loss of jobs for many financial managers. The failure of these financial institutions and the following shock of the financial sector qualified this crisis as a remarkable point among modern crises and indisputably as the most strong one with negative consequences for the real economy.

The 2008 financial crisis was also marked by extreme volatility in financial markets as well as by the significant fall of prices for mortgage related securities. Thus, markets for these financial instruments became illiquid, and the result was banks marking down their assets by significant amounts. Because of this, distress challenged banks’ capital requirements, and the amounts they were allowed to lend were reduced by billions of dollars.

Critics argue that those amounts could have aided the economy further, but instead, the financial institutions sold the assets for cash, which led to the extension of assets getting marked down, and the economic downward spiral became a certainly never-ending cycle.

From a financial stability viewpoint, it is interesting to underline that a specific trouble of the United States extended to the rest of the world through financial markets. The financial collapse due to the bankruptcy of the mortgage market (produced by the subprime mortgage market shock in the United States in August 2007) led to the alarming downturn of global economic growth (a decrease of 6.3% in the last trimester of 2008, as compared to growth of 4.0% in the previous year). The financial distress spread rapidly all over the world thanks to the globalization of financial systems and became the first global economic contraction since the Second World War.

Such a financial crisis developed from the subprime crisis into the credit crisis, then into a financial crisis and finally into a global financial crisis. This sequence produced unprecedented circumstances which gathered cumulatively over the last decade, undermining the trust in free markets. In any case, the uniqueness of the crisis in question has lead to an attempt to detect its causes and solutions to deal with it. In order to find explanations at the moment, it is essential to explore the causes and not the signs of the crisis because more systematic and global measures are needed than those applied thus far.

1.3Features of the financial crisis

The GFC was activated by a severe drop in house prices, and it is frequently attributed also to credit bubbles in the United States, but such a complex situation has shown a multidimensional feature. A bursting housing bubble, it seems, caused the crisis, principally, but not exclusively, in the United States. In any case, the collapsing housing bubble cannot be considered the single event which has generated the financial crisis.

We can mention a set of factors contributing to the crisis, such as, for example, the booming house-buying activity, the easy accessibility of loans in developed countries, the complexity of the financial instruments related to mortgage activity, and market agents’ behaviour – overly optimistic in boom periods and too pessimistic during bursts. To this list of macro and micro causes leading up to the unprecedented extent of the crisis can be added the undue leverage and excessive managers’ risk-taking attitude, which was incorrectly measured by rating agencies.

An important aspect underlined by specialized literature is the fact that such a severe crisis is not and cannot be caused by a single event, but it implies the failure of the whole financial system in assessing the risks linked to the fast growth of structured risks of mortgages and the exceptional lack of market liquidity (Ryan, 2008a).

From a very general point of view, the principal issue that reinforces most discussions on the origins of the GFC is a real estate bubble and then a crash.⁴ In the years immediately preceding the GFC, there was a real estate bubble that by 2006, due to both the resistance in the lending system and the irrationally valuation of real estate and subprime securities, forced the real estate process to unsustainably high levels.

Over the course of several years, banks built up large holdings of subprime mortgages and subprime securities (Shiller, 2008). These securities were overvalued because rating agencies and banks underestimated the level of future subprime defaults. It is widely agreed that this may have occurred because both households and banks acted irrationally in believing housing process would grow (Barberis, 2010). When house prices decreased, the bubble burst and carried out widespread defaults on subprime loans, which dropped the value of banks’ subprime-linked holdings and triggered an abnormal cycle in the banking system (Shiller, 2008; Martin, 2009; Gorton, 2009).

All of these factors demonstrated the inadequate conduct of financial institutions, especially of those lacking in sufficient reserves to withstand the shocks without restricting lending.⁵ Too many were overexposed because of their careless purchase of ‘toxic assets’, as well as their imprudent and excessively speculative behavior, light conformity with regulations on risk constraints (i.e., required reserve ratios) and disposal of huge amounts of cash as bonus payments.

These circumstances led to immense mortgage defaults and exposed enormous levels of the toxic assets, especially as a result of largely overvalued complex composites of unreliable mortgages, credit card and store loans, whose growth has been encouraged by confidence in still-increasing house prices. The outcome was enormous losses by financial institutions in many countries, including the United States and a number of European countries, as financial liberalization had enabled the international buying and selling of these toxic assets.

Moreover, in the years preceding the financial crisis, institutions built up large exposures to risky subprime and structured credit instruments. Subsequently, during the crisis years, prices for mortgage-related securities reduced considerably, and markets for them became illiquid. Banks had to recognize a decrease in the value of some of their financial assets, usually connected to subprime loans, and then fulfilled huge accounting write-downs because of the losses that occurred on exposures. Consequently, banks marked down their assets by considerable amounts and sold them to realize cash. Hence, during the crisis, the economic downturn became a vicious and seemingly never-ending cycle.

To enhance their financial position and to meet regulatory capital requirements, these institutions began to sell securities or shut down positions on some fina...

Table of contents

• Cover
• Title
• 1  Financial Crisis and Fair Value Accounting (FVA)
• 2  Fair Value Accounting (FVA): An Overview of Key Issues
• 3  The Role of Fair Value Accounting (FVA) in the Financial Crisis
• 4  Fair Value Accounting (FVA) in the Banking Sector
• Bibliography
• Index