Banking Crisis - Treasury Contents

Memorandum by Professor Michael Page


  1.  There are substantial grounds for believing that the financial reporting rules promulgated by the International Accounting Standards Board (IASB) and the US Financial Accounting Standards Board (FASB) contributed significantly to an excessive growth in lending by financial institutions, and to the subsequent near collapse of the financial markets. The most immediate issue is the marking of financial instruments to so-called "fair-value". The case against fair value is not so much that it requires entities to record assets at below their "hold to maturity" values after the market collapse, but that it contributed to the irrational exuberance of the bubble that preceded the crash.

  2.  In this memorandum I contend that fair value measurement contributed to the current crisis and that, in pursuing their current objective of financial reporting, the IASB is neglecting the important issues of financial stability and corporate governance that are fundamental to a good system of financial reporting. Before dealing with the particular issues upon which the Committee has requested evidence I want to make two fundamental points:

    2.1  Fair value measurement can lead to financial instability.

    2.2  Accounting principles should take account of wider economic concerns than decisions by capital providers.


  3.  The case for reporting market values is based on the hypothesis that markets are informationally efficient, so that the price recorded in a market reflects all publicly available information. However, even if that hypothesis is approximately correct averaged over a long period of time, market prices may be very unreliable measures of value at any given time. Moreover, market prices are "systemic" so that if the price of one security is a poor reflection of future values, then the prices of all securities are likely to be wrong. There is good evidence, theoretical and observational, that market prices are excessively volatile. Work by Schiller[3] among others has shown that variations in the level of stock market prices are too great to be explained by subsequent variations in dividends; and, theoretical work by Plantin, Sapra and Shin.[4] among others shows that marking to market can lead to excess volatility, particularly where traders tend to copy each other, for example because of bonus scheme arrangements or in reaction to rumours.

  4.  Advocates of marking to market frequently assert that market values "tell things as they are" or that "there is no better alternative". However, the assets and liabilities to which the values are applied are usually not going to be sold or transferred, and if they were, very different amounts would be realised, because the markets from which the prices are derived have substantial imperfections.[5] It would not be stating the case to strongly to say that the "fair-values" that accounting standard setters currently aspire to are "guesses of prices set by hypothetical market participants in markets that don't exist for items that aren't going to be transferred".

  5.  As to the assertion that there is no reasonable alternative, I contend amortised historical cost accounting (HCA) is viable. HCA uses either the "lower of cost or recoverable amount", for non-current assets, and "lower of cost or market value", for current assets. Certain items have zero initial cost, but zero is a perfectly good number.

  6.  This is not to say that current values should not be reported in notes to financial statements; transparency is a good thing. What it does say is that profits should not be calculated on the basis of excessively volatile market prices, since to do so gives companies, particularly financial companies, incentives to borrow excessively and take other excessive financial risks. Where individuals are remunerated on the basis of mark-to-market based profits, excessive volatility is translated into an incentive for enormous risk taking, since individuals can become independently wealthy an the basis of a couple of good years and aren't required to bear losses when the markets turn down.


  7.  Both the IASB and the FASB have "Conceptual Frameworks"—sets of principles that are supposed to guide the setting of accounting standards. The current conceptual frameworks have twin objectives of providing information useful to people making economic decisions and showing the "stewardship" that managers have exerted over entities. Not withstanding that both bodies are tasked with broad economic objectives, the standard setters have focused on providing information for participants in financial markets. The bodies have recently published an exposure draft (ED) of a new objective (see below paragraph 10) for a common conceptual framework that focuses almost entirely on information needs of "capital providers" and in which "stewardship" disappears as a separate objective. The ED explicitly rejects the notion that financial reporting should have a role in corporate governance.

  8.  The investor focus is convenient for the FASB and IASB because they can claim that accounting standards are only providing information and do not affect the behaviour of economic actors. This claim is invalid. Moreover the tradition of UK company law is that the prime role of financial reporting is as a governance device: its primary function is to guard against dishonest or incompetent company managements making free with investors' and creditors' money. Because of the safeguards financial reporting has provided, many financial and commercial relationships are possible that would not otherwise be possible, to the benefit of the diversity and stability of the economy. By neglecting this role of financial reporting the standard setters have done great disservice to the national and global economy.


  9.  Like any complex activity financial reporting has multiple purposes: it encourages management to act in the interests of stakeholders; it contributes to the smooth running of financial markets (except when it doesn't); it forms a basis for a wide range of possible economic relationships that could not otherwise exist; it assists competition to work in factor markets; it is a source of information useful for regulation of entities and control of the economy; it may help direct funds to economically productive uses.

  10.  In their recent exposure draft of a conceptual framework for financial reporting, the IASB and FASB would have us believe that the objective of financial statements is simply:

    To provide financial information about the reporting entity that is useful to present and potential equity investors, lenders and other creditors in making decisions in their capacity as capital providers.

  11.  This is hardly a statement of "purpose" and we are presumably meant to infer that the objective serves the purpose of helping secondary financial markets run smoothly. In my view this is a partial view of the purpose of financial reporting. As stated above the current conceptual frameworks of IASB and FASB have separate stewardship objectives that are to be subsumed within the new objective of providing information to equity holders in their capacity as owners. This misses the point: the objective of stewardship reporting is encourage management to act in the interests of stakeholders. In that respect financial reporting has an objective of maintaining good corporate governance and constraining the behaviour of management by encouraging managers to be diligent and honest. The ED denies that financial reporting has any role in corporate governance or in affecting the behaviour of anyone in a predetermined way.


  12.  Some idea of the scale of the impact of fair value accounting can be gauged be the reported impact on the financial results of Schroders of moving items from "marking to market" to "held to maturity" as permitted by the recent change to IAS 39 "Financial Instruments: Recognition and Measurement". In the case of Schroders, eliminating the market undervaluation turns £50 million loss into a profit. Financial assets were overvalued on a similar scale before the credit crunch. When markets are over-valued there are built-in incentives for individuals to keep them that way. Moreover in so far as overvalued markets lead to overvaluation of banks' reserves for the purpose of calculating reserve ratios, then marking to market leads to an expansion of lending many times the amount of the overvaluation. If this lending then fuels further overvaluation, a positive feedback loop is set up, leading to a bubble and to a subsequent crash, when, eventually, logic reasserts itself.

  13.  Such events are considerably less likely to occur if accounting measurement is done on a prudent basis such as HCA, since gains are not recognised until they are realised, but losses are recognised immediately. Recent events show the losses from overvaluation are much greater than the costs of the moderate undervaluation that can arise through prudent accounting.

  14.  The exact role that financial overvaluation arising from fair value accounting played in the current crisis is extremely complex and will take a long time to unravel. Because the crisis is the product of the system rather any individual entity, no on is in a position to say how the effects of overvaluation were transmitted through the market. Nevertheless, after recent events, and reflecting that marking to market was also a factor in the Enron crisis, the onus of proof about the usefulness of marking to market seems to be upon its proponents rather than upon its critics.

  15.  Marking to market has also been damaging to pension schemes and has been an important factor in the withdrawal of defined benefit schemes.

  16.  Market values are too unreliable to used in accounting measurements and accounting should revert to an amortised historical cost basis of measurement, with very few exceptions. This would have the advantage of forcing preparers of financial statements and managers to evaluate the intrinsic value of items rather than relying on market value.


  17.  The IASB is a private sector body and largely self-perpetuating. Under the leadership of Sir David Tweedie it has grown hugely in authority and influence. When the EU recognised a version of the IASB's standards it did the IASB a great service and added impetus to the IASB's ambition that its standards should be accepted for the purpose of registration of securities on American stock exchanges.

  18.  The main role the IASB should play in EU financial reporting is that of saving the EU the trouble and expense of setting its own standards. As an external body with a representative council and extensive due process the IASB tries to imbue its standards with legitimacy arising from independence and intellectual and moral persuasion. One may surmise that it is concern with legitimacy that makes the IASB reluctant to acknowledge that setting standards for financial reporting necessarily advantages some economic parties and disadvantages others. Focusing on market values and the needs of investors is a great advantage to the IASB since it can claim that it is only setting out to make people better informed by requiring the provision of relevant and reliable information. This claim does not stand up to examination, and in attempting to claim that financial information can be neutral as between parties the IASB ignores its wider responsibilities to the economies of its client accounting regimes. In particular the IASB does not examine the impact of its pronouncements on the stability of markets or on corporate governance: it acts as if its standards could not have unintended consequences.

  19.  There is reason for concern that the IASB is insufficiently accountable. There are signs that the board proceeds in a doctrinaire manner, (over the matter of valuation, for example) and is at times insensitive to the views of respondents to its consultations. For example, a large majority of respondents to its initial discussion paper on the conceptual framework were in favour of a separate stewardship objective for financial reporting, but a separate objective has not appeared in the subsequent exposure draft.

  20.  Some critics have observed that the IASB has been acting as if it were preparing the way for a full fair value measurement system. Although the Chair of IASB says this is not the case, proposals for extension of fair value continue to arise.

  21.  The status quo whereby the IASB issues standards and the EU endorses them is unlikely to persist. The IASB can hardly make itself fully accountable to the EU and at the same time the EU can hardly resign sovereignty in this area to a private body. Particularly if extensions to fair value that tend to destabilise company profits and financial markets continue, the EU Accounting Regulatory Committee is likely to recommend further amendments until a distinctive European set of generally accepted accounting principles emerges.


  22.  The IASB has the appearance of adequate due process but the process by which issues are added to the work programme is somewhat opaque and, as mentioned above, the views of respondents to its consultations do not seem, at times, to be fully accepted.


  23.  Marking to market accounting should be dropped, not just because it makes the crash worse, but because it was a necessary condition for the bubble that preceded the crash. Accounting standard setters should focus on setting standards that lead to economic stability rather than reflecting back at financial markets unreliable market prices.

  24.  The UK and the EU should adopt a more critical view towards the proposals of the IASB and should seriously consider reverting to amortised historical cost accounting wherever fair value is currently mandated.

3 November 2008

3   Robert J Schiller (2000) Irrational Exuberance Princeton University Press. Back

4   Gulliame Plantin, Haresh Sapra, Hyun Song Shin (2008) "Marking-to-Market: Panacea or Pandora's Box?" Journal of Accounting Research 46,2 pp 435-460. Back

5   Page, M., & Whittington, G. (2007). The price of everything and the value of nothing? Accountancy, 140(1369), 92-93. Back

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