FAIR VALUE ACCOUNTING

Fair Value Accounting

Fair Value Accounting

Introduction

Most analysts agree that the growing application of fair value accounting to banks' activities has improved pricing discipline, made loan pricing more risk sensitive, and minimized opportunities to arbitrage banks versus the bond market. As described in an earlier article in this series, this has been a 25-year transition from an originate-and-hold to an originate-and-distribute business model. As bank loans became more liquid and as securitization became a core operational strategy for most banks of significant size, pricing loans consistent with the market-determined cost of credit was essential.

While improved credit allocation is a net positive result of greater fair-value accounting, this series also has argued that fair value is not a complete measure of bank performance. While mark-to-market values are based on all available public information, much of a bank's long-term value lies in confidential, nonpublic information. This difference plays an especially significant role in times of crisis, when market decisions are driven predominately by fear especially fear of the unknown.

Objective

The experience of significant asset write-downs and the reported losses over the past year should get us thinking about the potential dangers of applying mark-to-market accounting across the board. Most analysts agree that markets probably have overreacted in their markdowns of structured assets. This overreaction is quite understandable given the lack of transparency around the underlying collateral and uncertainty about how the complex structuring will play out over time. Nevertheless, it probably overstates the impact of subprime mortgage defaults on the ultimate recovery value of these assets.

In this report we are going to discuss that How fair value accounting led to the volatility of banks performances in UK during 2003-2008 and what can be done to prevent this from happening again.

Background

It is believed that fair value is the most appropriate measure for financial instruments and that all changes in fair value should be reported as income in the period in which the change takes place. It considers that fair value measurement is needed because of conceptual and practical problems associated with measuring items in the trading book at fair value and items in the banking book on a historical cost basis.

The draft standard published by the JWG proposes radical changes to the way in which the primary financial statements are prepared. It is concerned with measurement and not just disclosure. Under the JWG proposals, the primary financial statements would include estimated fair values of loans and other non-marketable assets (Shleifer 2005). This would be on the basis of a comparison of the yield obtained under the original transaction with the yield that would be obtained on a new transaction of a similar type. Any difference in value between the existing transaction and the current equivalent would be recognised immediately.

The proposals therefore are not just about the calculation of fair values through a net present valuation of future cash flows, but involve a recalibration of the yield from existing transactions according to the yield that would be obtained from ...