Welcome to the first edition of the Genesis Analytics Bank Board and Corporate Governance Brief for the Middle East. In these monthly briefs, we will be exploring some of the key issues in banking and corporate governance today, and will be examining what they mean for banks and financial institutions operating in the region.
We begin by taking a look at the role that fair value accounting had to play in the global financial crisis, and ask whether calls for a re-evaluation of how it is applied are justified.
In the March edition of the Harvard Business Review, the Chair of MFS Investment Management, Robert C. Pozen, asked what is, for many, a vexed question: “Is it fair to blame fair value accounting for the global financial crisis?”. The answer is far from simple, but Pozen’sexploration of the issue is illuminating.
Mark-to-market or fair value accounting has received a bad rap, and some commentators -including Steve Forbes, the Chairman of Forbes Media -have laid the blame for the entire financial crisis at its door. Pozen, however, questions whether this practice, which pegs the value of assets to their real value in the open market, can really be blamed for the shockwave that pulsed through the world financial markets eighteen months ago.
Some bankers have claimed it was fair value accounting that precipitated the global crisis after the credit freeze of 2008 drove down the value of key assets in their portfolios to record lows. They have argued that fair value accounting rules affected the value of these assets so badly that, although the majority of mortgages, corporate bonds and structured debts were still performing, many banks found themselves facing insolvency.
Persuaded by these arguments, politicians in both the US and Europe have called for a suspension of fair value rules in favor of historical cost accounting, which allows for assets to be valued at their original or purchase price. Fair value accounting, however, has its defenders, amongst them Lisa Kroonce, an accounting professor at the University of Texas.
“This is simply a case of blaming the messenger,” she said in an article in Texas magazine recently. “Fair value accounting is not the cause of the current crisis. Rather it communicated the effects of such bad decisions as granting subprime loans and writing credit default swaps… The alternative, keeping those loans on the books at their original amounts is tantamount to ignoring reality.” Shareholder groups and the Financial Accounting Standards Board (FASB) back this position, claiming that it is more important than ever to know the real market value of assets in bank portfolios.
So is this a black and white issue, or is there more to it than that?
Genesis Analytics would argue it is not only accounting practices that matter in times of crisis, but also the depth with which banking boards understand both the rules and the issues they reflect. Obviously, it is in no-one’s best interests for banks to go bankrupt because of short-term fluctuations in value. By the same token, it is in no-one’s best interests to hide losses from investors, or to delay the cleanup of toxic assets if and when necessary.
It has therefore become clear that, in order to take the legitimate needs of both banks and investors into account, a new multidimensional approach to financial reporting needs to be adopted, one which takes both historic value and mark-to-market value into account.
Before this can be done, though, it is important that some misconceptions about accounting rules and methods be cleared up.
For one thing, it is incorrect to assume that historical cost accounting has no connection to current market value. Granted, under historical accounting rules, most assets are carried at their purchase price or original value, with minor adjustments for depreciation over their lifetime (as in the case of buildings) or for appreciation until maturity (as in the case of bonds bought at a discount to par). However, even under these rules, current market values are factored into financial statements, and listed companies and financial institutions have to report on whether any of their assets have been permanently impaired. So, even if assets are being carried at their original value, institutions have no option other than to report a permanent decrease in their value if this occurs, although they are able to do this in a more measured way than fair value accounting rules allow for.
It is also incorrect to assume that most of the assets held by financial institutions are marked to market. In fact, according to an SEC study conducted in 2008, only around 30% of bank assets are treated in this way, and the rest are accounted for at the historical cost. This is because, under fair value rules, management is required to divide the institution’s assets into three categories: those that are held, those that are traded and those that are for sale.
So, if management intends and has the ability to hold certain assets to maturity, they are carried on the books at historical cost, and are only written down if permanently impaired. In contrast, all traded assets are marked to market on a quarterly basis, and any decrease in the fair market value of a bank’s traded assets have to be reported on that basis.
Finally, there would be no question about fair value accounting if all assets were highly liquid and easy to value at direct market prices, but this is obviously not the case. As markets are not always liquid, fair accounting rules do, however, allow for two additional levels of evaluation which permit bank executives to value assets based on observable market inputs or on original cost.
So, when all the dust has settled, it becomes clear that historic cost accounting and fair value accounting are not as far apart as they may seem. The art of managing a bank or financial institution through a crisis clearly lies in something greater than accounting rules. At times like these, it falls to bank boards to equip themselves with the knowledge and information required to make in-depth and informed decisions. In a dramatically changed financial services environment, only boards that have this kind of in-depth understanding are able to keep their institutions on a steady course in even the most challenging of times.
KEY POINTS FOR BOARD MEMBERS:
-Fair value accounting is a fundamental governance issue that has a direct impact on bank performance
-It is important to understand the movement of assets between different categories, and the bank’s auditors should be asked to give details of any such movements should they occur
-It is equally important understand the assumptions on which the valuation of assets and their classification into different categories are based
-Major changes in classification should be carefully monitored
-It is vital to understand the fair value accounting rules that apply within the jurisdiction that the bank operates
Genesis Analytics recommends that bank boards avail themselves of facilitated briefing and strategy sessions on a regular basis in order to ensure they are properly equipped to deal with a constantly-changing financial services environment. Genesis Analytics is an advisory firm that works with the boards of financial services institutions in order to improve their insight into and understanding of the institutions they govern, as well as the context in which they operate.
Richard Ketley is a director of Genesis Analytics. He is widely recognized and consulted as a leading expert on banking in Africa. Richard has lead assignments with banks and financial institutions for over 7 years. Richard holds a Bachelor of Arts (Honors) degree from the University of the Witwatersrand, and a Master of Science in Economics from London University, where he specialized in finance.
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