Discussing the credit crunch

 

As the credit crunch and its consequences have unfolded there has been much discussion about the issue of fair value and where accounting standards fit into the crisis.

Here IASB Chairman Sir David Tweedie, and Board member John Smith, discuss the issues.

 

‘There has been a lot of talk about volatility in the marketplace’, says Smith. ‘People talk of accounting for volatility as though it has caused this crisis. Volatility is not invented, and when companies report volatility that volatility is real. The change in assets and liabilities is an economic event and all businesses are exposed to economic volatility’, he adds. ‘It results from things in the marketplace changing. And all the accounting does is describe it.’ But that accounting has come under attack. How far has this been a case of ‘shooting the messenger’? ‘Mark-to-market or fair value accounting has been attacked by some in the press, but others are of the opinion that the transparency and disclosure provided by fair value has helped to disclose the true economic position earlier’, says Tweedie. According to a survey of CFA Institute members worldwide, 79 percent of respondents believe that fair value requirements improve transparency and contribute to investor understanding of financial institutions’ risk. Bad lending

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‘Fair value accounting has been accused by some of exacerbating the present financial crisis. Perhaps we should get a few points clear. The crisis has been caused by bad lending which has then been scattered around the world by banking’s “originate loans and then distribute them” policies. These loans have been sliced and diced in many ways and wrapped up in complex financial instruments that probably stretched the ratings agencies to their limits and probably gave some investors who didn’t do enough due diligence more assurance than they should have, and because the banks had distributed the loans these loans probably moved outside the banks’ risk assessment practices’ explains Tweedie.

 

John Smith adds: ‘A major part of the problem is that markets are unsure where these bad loans have ended up and consequently have marked down any instruments suspected of containing them. The use of fair value is not new. Fair value has long been used to determine how much a bank can recover from a loan. The valuation of loans, therefore, has always been on a fair value basis when full recovery is uncertain.’

 

 

Lack of trust

 

Much talk has been made of the alleged pro-cyclic effect of mark-to-market accounting.

David Tweedie sees the issue from a slightly different angle: ‘Some of the complaint has been that the valuation has been artificially low and will recover in the future. This could well be the case. But accounts are supposed to reflect the current situation, not a probable future one. Ultimately, it is lack of trust that has caused the present market problems. And in that sense, picking a value that one hopes might be the value in a year or two is hardly likely to increase the trust as each institution probably has a rather different view of the future. ‘Leaving these instruments at cost when everyone knows their value is impaired is an equally bad idea. As some have said, fair value is probably the worst possible measurement system apart from all the others’, he says.

John Smith provides an example in another walk of life:

‘Think of a teenager who has been told that if he gets good grades at school then his parents will buy him a car. He gets the grades and he gets the car. But he has so much fun in it that he takes his eyes off the ball and his grades start to fall. He is worried so he goes to the head teacher and asks him not to send his grades to his parents and argues they don’t reflect all the work he has done. He asks for an average of his grades over the year to be sent out to his parents instead. What would happen? He would be chucked out of the head teacher’s office but that is what is going on in the business world at the moment.’

Smith argues that if the accounting did not disclose what was going on, the problems could have only got
worse. ‘By denying this information to the marketplace the real problems wouldn’t have been discovered until a
year or two down the road and it would by then be worse.’

And the accounting issues are nothing to do with the economic realities. ‘Whether you use fair value or not
the losses would still exist. The fact that they have been reported means that the problems are now being attended to’ says Smith.

For him the current situation is an essential lesson for managers in how to manage their risks. ‘In order to
manage risk they have to measure it’, he says, ‘and that is one thing that fair value requires. It is a measurement.

Managers may not like reporting it, I can understand that, but they are accountable for how well they manage the risk and so they should be reporting it.’

‘It should be remembered that the European Central Bank’, comments Tweedie, ‘concluded just over a year and a half ago that consistent and rigorous application of IFRSs would increase the stability of the financial system by strengthening the banks’ internal discipline and risk management in the medium term.

IFRSs have resulted in much more information on derivatives being published than ever before. In the absence of such information markets would probably be more volatile than they are today’, he says.

A silver lining

 

There can even be a silver lining. ‘Even the fact that markets are low today enables people who did not purchase the instruments at the centre of the crisis to move into the market and purchase these instruments and be rewarded for their caution’, Tweedie continues.

‘Accounting has to reflect facts, not assume stability when it doesn’t exist.’

Long before the credit crunch the IASB had been examining the issues of consolidation and recognition.  The question of special investment vehicles and other ways of taking something off balance sheet is part of that review. ‘Think of risk and think of the requirement under IFRS 7 to disclose various types of risk’, says Smith. ‘It doesn’t matter whether the entity is consolidated or not consolidated.’ He underlines that the risk is still there and should hence be reported: ‘The extent of risk should always be disclosed and be transparent.’

Providing further enhancements to transparency and disclosure is at the heart of a recent report by the Financial Stability Forum (FSF), a meeting of senior regulatory and supervisory bodies, as well as other international institutions. Amongst a range of recommendations the FSF called on the IASB to expedite the consolidations and derecognition projects already on the work plan by skipping the optional due process step of publishing a discussion paper and moving straight to exposure draft stage.

The report also supported plans for the IASB to form an expert group to assist in providing further guidance on how to apply fair value measurement in illiquid markets.

‘We are supportive of the recommendations set out in the FSF report and will work with others to ensure that any lessons to be learnt from the crisis are dealt with appropriately’, concluded Tweedie.