Banking Crisis: reforming corporate governance and pay in the City - Treasury Contents

7  Fair value accounting

Fair value accounting in the banking crisis

248. Most financial instruments held by banks for trading are measured using fair value accounting. Under normal circumstances, where there is an active market for the instrument, this is simply its current market value. Where a market value is unavailable or unreliable, fair value "is an estimate of what the market value would be if there were a market".[405] For this reason, fair value is also referred to as mark-to-market. Some commentators have argued that fair value accounting contributed to the financial crisis by exaggerating the severity of problems in banks' assets portfolios.

249. The main alternative method to fair value is historical cost accounting, which involves the recording of assets on the balance sheet at their acquisition price. According to the ICAEW there were two major differences between fair value accounting and historical cost accounting. Fair value recognises unrealised gains, when asset values rise above their cost, whereas historical cost only recognises realised gains, such as gains arising from the sale of an asset. Secondly, whilst both methods recognise a fall in the value of an asset, fair value means the assets are written down to their new fair value, but under historical cost accounting the asset remains at historical cost and an impairment provision is made, based on the management's estimate of current net losses. Under fair value, the market price used will reflect expectations of both current and future gains and losses. The ICAEW commented that historical cost valuations might therefore provide a higher valuation than fair value because they did not take account of expected future losses, which the market, and therefore fair value, would take into account. Summarising, the ICAEW said that "when calculating the extent of write downs, there is a risk under fair value that prices from 'unduly depressed' markets will be reflected in the accounts. Under historical cost there is a risk that the accounts will reflect undue managerial optimism".[406]

250. Charles Cronin, for the Chartered Financial Analyst (CFA) Institute,[407] argued that because historical cost accounting was "backward-looking" and subject to management judgment, whereas fair value accounting used market opinion, investors wished to see broader use of fair value accounting".[408] The IMA argued that there was no satisfactory alternative to fair value, observing that the recording of values at historical cost "would reflect an arbitrary moment in history" when the assets had initially been acquired.[409] Stephen Haddrill, for the Association of British Insurers (ABI), agreed that the fair value method was preferable, but told us that investors only wished to see fair value accounting being used where there was a "deep and liquid market".[410]

251. Paul Chisnall, for the British Bankers' Association (BBA), disputed that the historical cost model was backward-looking, and strongly believed that historical cost accounting was appropriate in valuing instruments to be held over the longer term, because, unlike fair value, the historical cost model did not require a spot price, which was of little relevance unless the instrument was being sold.[411] Russell Picot, a member of the BBA's Financial Reporting Advisory Panel agreed, stressing the importance of the accounting system reflecting "the underlying economics and cashflows":

if you have a trading activity, then the use of a market value approach is appropriate, but, where you have got assets and liabilities held for the long term, then it is not actually appropriate to then force short-term fluctuations in values through the balance sheets and profit and loss accounts of companies.[412]

252. The debate surrounding the relative merits of fair value measurement vis-à-vis historical cost accounting is not a new one, but it has become particularly pertinent as the financial crisis has developed. The BBA contended that the application of fair value accounting during the financial crisis, when markets had effectively broken down, had contributed to a "spiral of write-downs" and resulted in damage to banks' capital ratios.[413] The problem with fair value accounting, surmised Mr Chisnall, was that it presumed the existence of deep and liquid markets, which had clearly proven inappropriate for certain asset classes.[414] Mr Picot explained the problem in the following terms:

Where you have got active markets, there is going to be a willing buyer/willing seller approach, but what we have seen is very illiquid markets with very thin transactions and, in some cases, complete illiquidity, so what has been happening is that some of the banks have been effectively forced into ever-decreasing values based on very thin transactions or, in some cases, no transactions and then they have used models using the credit spreads, and obviously credit spreads have expanded very significantly over the last year and that has driven down asset prices and that has, in turn, to some extent, contributed to the downward pressure where there have been more sellers than buyers.[415]

253. Several of our witnesses defended the use of fair value accounting in the financial crisis. Sir David Tweedie, the Chairman of the International Accounting Standards Board (IASB) argued that fair value accounting recognised current problems faster than alternative valuation methods would have done: "the beauty about fair value accounting … is that it brought this crisis very, very quickly into the open, and if it had not then I suspect we might still be having sub-prime lending going on, even now, and the disaster would be even worse".[416] Michael Izza, the Chief Executive of the ICAEW made a similar point: "painful though fair value may be, it has got the news out much faster than other methodologies might have done, leading to speedier actions to deal with the situation. It is very important that we do not seek to shoot the messenger, in these circumstances".[417] Mr Cronin thought that the reason for the significant write-downs of bank assets was the fact that many assets were indeed worth much less than before. He argued that focussing on fair value was a distraction from the real issues—asset quality and lending policies:[418]

a lot of [assets in these complex structured products] are suffering. They are not honouring their obligations, they are not paying the interest rate and there are write-downs in progress … the market is saying that these assets have become more risky and, hence, they are worth less.[419]

Paul Boyle, Chief Executive of the Financial Reporting Council, agreed that if there were no buyers in a market for a particular asset, then perhaps the real value of that asset was indeed zero—and fair value accounting forced people to come to terms with that truth.[420] Liz Murrall, for the IMA, said that fair value accounting was not to blame at all, but more that the problems were triggered by financial institutions indulging in excessive leverage, poor risk controls and incentive structures that encouraged people to take risks.[421]

254. Fair value accounting has led to banks publishing some very dispiriting financial results, but this is because the news itself has been bad, not the way in which it has been presented. The uncomfortable truth for banks is that market participants had over-inflated asset prices which have subsequently corrected dramatically. Fair value accounting has actually exposed this correction, and done so more quickly than an alternative method would have done. Important features of accounting frameworks are that they encourage transparency and consistency across firms and asset classes. But it is a bridge too far to expect them to also lead to intelligent decision-making. We do not consider fair value accounting to be a suitable scapegoat for the hubris, poor risk controls and bad decisions of the banking sector.

Fair value accounting and procyclicality

255. Many witnesses argued that fair value accounting had exacerbated problems in the financial crisis through its procyclical interaction with regulatory capital requirements. Mr Picot said this had particularly become the case since the adoption in the EU of Basel II capital requirements for banks. He explained the vicious circle of procyclicality to us:

As the credit quality of loans decreases, so the amount of [required] risk-weighted assets and, therefore, [required] capital increases … as a bank writes down its trading assets, so its profits will diminish and, therefore, the amount of capital it generates will diminish and, if that is at the same time, as it is at the moment, as its risk- weighted assets are rising because of credit quality falling, you do get that reinforcing, that pro-cyclical effect. I have to say, if we were on a full fair value accounting basis, the consequences for reported numbers would be very, very severe.[422]

Ms Murrall agreed that the interaction of fair value accounting and Basel II capital requirements was pro-cyclical:

institutions have to write assets down when they are marking them to market in the current climate and this puts pressure on their capital, they then have to sell assets to raise that capital and, hence, you get this downward spiral.[423]

But she argued that this issue could be addressed "quite simply" by decoupling the financial reporting requirements of listed institutions to the market, and the prudential capital requirements of the regulator. [424] Mr Haddrill echoed that theme:  

people are not drawing a distinction between accounting, which is trying to give the markets the best possible view, and regulation, which then, if it just responds to that view in a mechanistic way and does not take account of the fact that markets will turn back and so on, leads to institutions having to do things which are damaging and pro-cyclical, and I think we need to distinguish between the story we get out of accounting, we have to learn from that and take a view on that, and then make sure that we do not have pro-cyclical regulation just automatically picking it up.[425]

256. Sir David Tweedie was confident that it would be possible to break the link between accounting and capital regulation, giving the banking supervisors the information they required without affecting the integrity of accounting.[426] Mr Boyle also argued for a separation of the basis on which accounting operated from the way in which prudential capital requirements were calculated:

The purpose of accounting is to present an unbiased picture of the financial health of an organisation. The purpose of prudential regulation is biased. It is properly biased; it is proper that the Financial Services Authority should be biased in favour of protecting depositors or protecting policy holders. So they have different objectives and, therefore, they can use different numbers … To give investors confidence you need to present an unbiased version of the truth; to give depositors confidence you need to give them some confidence that … "rainy day" money is being built up during the good times so that it can be spent in the bad times. … Prudential regulators already have, and already use, powers to base their calculation of regulatory capital on different bases than the accounts. They start with the accounts but then they properly make adjustments, and it is up to them, based on their regulatory objectives, to decide what the appropriate adjustments are. That can be done nationally and, also, it can be done internationally by the banking supervisors.[427]

Lord Turner told us that there was intense debate between regulators and accountants about how to meet both the requirements for clear communication of facts to shareholders, but also the desire of regulators to have something in the accounts that recognised systemic risk and economic cycles. However, whatever approach was taken, continued Lord Turner, ought to be agreed in concert with international bodies such as the IASB, because "we simply cannot run a system, certainly not in Europe and ideally not indeed in the world, where we have different accounting systems in one part of the world from another part of the world".[428]

257. We consider that fair value accounting has featured an element of pro-cyclicality through its interlinkage with the Basel capital requirements. This is not a fault of the accounting standards, but rather a result of published accounts being used too crudely in the calculation of regulatory capital requirements. The primary audience of accounts are the shareholders, who have a desire to see the true worth of their firm. The FSA, as the banks' supervisor, is a secondary user of the accounts, and has a legitimate interest in ensuring that firms are run prudently. This is not the same objective as that of the shareholder, so the regulator need not rely, and certainly should not rely exclusively, on the published accounts in calculating capital requirements. We will consider ways in which the FSA might introduce such an element of prudence in the capital regime in our forthcoming report on public regulation.

Response by the IASB

258. On 13 October 2008 the IASB issued amendments to its international accounting standards that permitted the reclassification of some financial instruments, in order to bring them into line with US practice.[429] As a result of the amendments, banks would be able to transfer financial instruments from the trading book to the banking book, if the firm's management's intentions changed as a result of trading becoming unfeasible due to markets collapsing. The change was good news for banks, which would now be able to apply historical cost accounting to instruments which previously had been subject to the dramatic write downs of the fair value method in the trading book. The IASB reasoned that the deterioration of the world's financial markets during the third quarter of 2008 "justified bringing IFRSs largely into line with practice in the United States, therefore justifying the amendment's immediate publication".[430] Mr Picot welcomed the changes made by the IASB, saying that "they did even up the playing field vis-à-vis the US and they did give some relief from unnecessary write-downs".[431]

259. In making the specific amendment on 13 October, the IASB noted the concern expressed by EU leaders and finance ministers through the ECOFIN Council to ensure that "European financial institutions are not disadvantaged vis-à-vis their international competitors in terms of accounting rules and of their interpretation".[432] The IASB was also lobbied by the European Commission (EC) directly, to Sir David's chagrin, who said that the EC's actions amounted to "a blunt threat to blow the organisation [the IASB] away … that came very, very rapidly".[433] This section of the Report examines the unseemly spat between the IASB and the EC.

260. Prior to their adoption within the EU, the IASB's standards are scrutinised by the European Financial Reporting Advisory Group (EFRAG), set up by the EC in 2001.[434] The EC has the power to 'carve-out' any elements of the IASB's standards of which EFRAG does not approve. Sir David Tweedie told us that the EC had threatened to carve-out an element of International Accounting Standard (IAS) 39 that prohibited banks from reclassifying financial instruments from the trading book to the banking book, unless the IASB acted speedily to amend IAS 39 itself.[435] The effect of such a carve-out, according to Sir David, would have been a free-for-all in banks' financial reporting:

[Banks] would be able to transfer out of things like the trading account into some other account … without any controls whatsoever … I think accounting in Europe would have been totally out of control if they had used the option to take the "carve-out".[436]

261. Rather than allow the EC to create such a situation, the IASB agreed to the EC's demands for change. By drawing up amendments to IAS 39, the IASB was able to insert new disclosure requirements (for example, requiring the additional disclosure of the fair value of those assets that had been reclassified), which the EC carve-out could not have introduced.

262. Mr Picot told us that "the overwhelming consensus of stakeholders" involved in the EC's process had not been to ask for a carve-out, and he stressed how important it was that all parties respected the due process of the IASB, as the independent standard-setter.[437] Mr Haddrill speculated that the EC itself was "under pressure from the French Government" and "the French financial community".[438] Mr Cronin agreed, bemoaning the situation where "what we have got at the moment is the European Commission via the French banking sector essentially altering the rules that are to their own benefit".[439]

263. Sir David told us that if the IASB had not acceded to the EC's demands, triggering the threatened carve-out, then the credibility and reputation of the IASB would have been in jeopardy:

If Europe had yet another "carve-out" I think you would have found the United States saying: "This is impossible; we're not going to have global standards after all". The whole idea of the US moving towards IFRS has been based on the fact that you have got Europe doing it, Japan's agreement to 2011, China did it last year and you have got India and Korea coming in, and then suddenly Europe moves out. That would have crippled the whole global process.[440]

Whilst the IASB may have avoided the most damaging threat to its credibility by acceding to the EC's demands, Sir David Tweedie admitted that the IASB had been damaged:

I was in the United States a fortnight ago and there were questions of: "Why did you do this? This is European influence. Are you a European body?" Other countries that were completely taken by surprise—because all of this happened very, very quickly—have to put it through their legislature sometime; the standards lie on the table in parliament for so many days … and suddenly they were given something they had no knowledge was coming. That was a major problem for us. It upset a great deal of people.[441]

Sir David told us that he had considered resigning over the EC's demands, but decided not to, in order to persevere with the mission of establishing a single global set of accounting standards, which, he said, the IASB were "almost on the verge of winning". Nevertheless, he was of the view that the IASB "could not survive" another carve-out by the EC.[442] Mr Cronin told us that this was the first time there had been a "direct threat to the independence of the IASB through pressure from the European Union". In his view, the IASB had "put a very brave face on it", but had had little choice but to accept the EC's demands. If the IASB had to cave in again, "then the game may be up in the convergence agenda".[443] Michael Izza, the Chief Executive of the ICAEW, agreed that the IASB had been damaged by the episode.[444] Mr Boyle said the IASB was caught "between a rock and a hard place", as the alternative for the IASB "would have been even worse". He added that it would be "extremely damaging if accounting standards are made, in effect, by politicians for political reasons".[445]

264. The European Commission sent a letter to the IASB on 27 October 2008 requiring the IASB to address three further issues before publication of the banks' year-end results.[446] Mr Haddrill described this pressure as "lamentable", and argued that, "if the European Commission should be doing anything at the moment, it should be considering how to bolster the independence of a body [the IASB] that is the only global standard-setter we have in this area".[447] Mr Picot said it was "very important that in Europe we recognise that a single language of accounting is a very good thing". He was therefore very concerned by the European Commission's carve-out powers, because in the coming years, the IASB would come under pressure from recent adoptees of international accounting standards, such as China and the United States, and, if Europe did not "properly and fully endorse IFRSs", there was a real risk that a European voice would start "to get severely weakened and that would damage the interests of British and European companies significantly".[448]

265. Sir David told us that the IASB were rather taken by surprise by the EC's action: "It came very quickly ... and almost out of nowhere, so it took us by surprise. We were not expecting this at all."[449] The IASB was anyway in the process of considering changes to IAS39, in order to permit some reclassification of assets to bring international standards into line with US standards, but the EC was keen for a quicker decision than the IASB's planned timeline of one week. According to Sir David, the IASB had "no time whatsoever for consultation".[450]

266. Ms Murrall took the view that the IASB's decision to amend the accounting standards without any prior consultation was "a pragmatic response to a very difficult situation".[451] But Andrew Crockett, former General Manager of the Bank of International Settlements, questioned the wisdom of rushing through amendments without due consultation:

I do not believe that ad hoc shifts in valuation methods in crisis situations would help either manage a crisis or provide comfort to bank counterparties".[452]

Mr Haddrill thought that changing the accounting rules in the moment of crisis risked "undermining the confidence of people who may not understand at depth what is going on".[453] Mr Picot also thought it "very important, where you have an independent standard-setter, that the due process is respected because, quite frankly, not everyone is always going to agree with what the IASB says, but you have to trust their due process and accept what they come out with in the final outcome".[454] He added that there was a need for the IASB to have a "proper, fast-track [consultation] process, but with consultation on an accelerated basis".[455]

267. The existence of the European Commission's carve-out power seriously undermines the ability of the International Accounting Standards Board to project itself as a truly global setter of accounting standards, and indeed threatens the integrity of published accounts. Both are profoundly regrettable. Any threatened carve-out effectively presents the IASB with an invidious choice between losing the IASB's coverage of the European Union on the one hand, or acceding to the Commission's demands at the expense of a loss of credibility in other nations on the other. We are concerned that the IASB has already become tarnished by the accusation that it gave in too easily to the Commission's demands over fair value accounting, and by its suspension of its usual consultation process. We recommend that the Treasury consider the impact of the Commission's carve-out power on the prospects for the IASB's reputation and continuing work in establishing a global set of accounting standards.

4 405  05 Ev 22 Back

4 406  06 Ev 23 Back

4 407  07 The CFA Institute is a professional body representing investment professionals. Back

4 408  08 Q 134 Back

4 409  09 Ev 15 Back

4 410  10 Q 135 Back

4 411  11 Q 135 Back

4 412  12 Ibid. Back

4 413  13 Ev 311 Back

4 414  14 Q 159 Back

4 415  15 Q 136 Back

4 416  16 Q 220 Back

4 417  17 Q 221 Back

4 418  18 Q 166 Back

4 419  19 Q 137 Back

4 420  20 Q 229 Back

4 421  21 Q 146 Back

4 422  22 Q 149 Back

4 423  23 Q 151 Back

4 424  24 Ibid. Back

4 425  25 Q 138 Back

4 426  26 Qq 218-9 Back

4 427  27 Qq 220-1 Back

4 428  28 Q 2212 Back

4 429  29 Q 202 Back

4 430  30 Ev 73 Back

4 431  31 Q 170 Back

4 432  32 Ev 73 Back

4 433  33 Q 186 Back

4 434  34 See for more information about EFRAG. Back

4 435  35 Q 202 Back

4 436  36 Qq 186, 202 Back

4 437  37 Q 170 Back

4 438  38 Qq 174-5 Back

4 439  39 Q 180 Back

4 440  40 Q 202 Back

4 441  41 Q 207 Back

4 442  42 Qq 208-9 Back

4 443  43 Qq 169-170 Back

4 444  44 Q 188 Back

4 445  45 Ibid. Back

4 446  46 Back

4 447  47 Q 171  Back

4 448  48 Q 146 Back

4 449  49 Q 187 Back

4 450  50 Q 186 Back

4 451  51 Qq 178, 183l Back

4 452  52 Ev 294 Back

4 453  53 Q 162 Back

4 454  54 Q 170 Back

4 455  55 Qq 183-4 Back

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