Let me start with an analogy.
In football, as we know, the league table throughout the season is ordered by which team has accumulated the most and the least number of points and scored or conceded the most goals. Suddenly, the league managers association protests that due to external circumstances beyond its control (say, a flu epidemic has struck down half the league's players) that the league table is terribly unfair, and instead says that league positions should be based on the manager's expectation of how many points (plus goal difference) his team would achieve that season if normal conditions prevailed. Each manager declares what he himself describes as his realistic expectation, and the table is drawn up accordingly. Unfortunately, and inevitably, most managers will over-estimate the value of their team, and the estimates made will total significantly more than the total number of points available for the whole league for the season. Who gains? The league managers (for which, in this analogy, read the banks) on a somewhat short-term basis - at least until those overestimates are uncovered. Who loses? Everyone for whom it is important to know which team is doing well or badly (for which read bank share investors, regulators and governments).
Well, this may not be a perfect analogy, but it is what new banking regulations will mean in the world of financial accounting. Many of us have been warning of ill-conceived or counter-productive regulatory changes, and the changes outlined a small article tucked away in the corner of the Companies and Markets section of yesterday's FT will, in my view, be counter-productive and potentially disastrous. It may not be in the same league as the 1930 Smoot-Hawley Tariff Act, but the importance may come in showing the danger of hastily-conceived regulatory changes. I expect that this won't be the last such change.
The International Accounting Standards Board (or IASB) has decided, apparently against their better judgement, but under pressure from various EU countries, especially Germany, France and Italy, to follow the example of the US's Securities and Exchange Commission and ease rules on what is called "fair value" or "mark-to-market" accounting. This may sound obscure, but it is extremely important for transparency in financial markets - ironically one of the goals trumpeted by German politicians, who have here scored another own goal.
I have been in Brussels the last two days on a select committee visit, and I have used the opportunity to argue with anyone who will listen that the proposed change will be entirely counter-productive. To be fair, I think our Government agrees with me, but doesn't seem to have the clout to prevent it, despite their own belief that they are "leading the world" in this crisis.
Fair value or mark-to-market accounting means that securities and cashflows (like e.g. derivative transactions) must be valued at the current market level. This has taken some time to make the global industry standard. I recall Japanese banks in the 1980s using so-called "accrual accounting", where banks and companies simply declared the actual cashflow for that year, ignoring future flows, even if they were already known. It gave rise to accounting arbitrage - two banks, one Japanese and the other European or US could enter into a transaction and both show an immediate profit on their books. This was clearly therefore not a transaction properly accounted for, even if one could understand why both counterparties might be happy in the short-term. The advantage of mark-to-market accounting is that prices are derived independently from the holder of that security, and that all owners of the security would report the same price. This in turn is very important for investors in banks or companies, who need to have assurance that what is declared in the books is indeed "fair value."
Anyway, the progress made over the last 20 years looks set to be unravelled, ironically at the behest of various banks. Some banks are complaining that they are unable to achieve proper pricing on the securities or cashflows they hold, because there is simply no proper market pricing of complex derivatives at present, including Mortgage Backed Securities (or MBS). Therefore, they argue, their portfolios are being under-valued. Instead, they say, they should be allowed to value their securities and cashflows according to their own expectations of their value. This is very dangerous, abolishing the independent verification of pricing, and instead depending on the banks themselves who own the securities to provide their own valuations, which will inevitably be over-valuations - who would under-value them if your bonus and even your job depended on it?
The consequence is that investors and banking regulators will start to lose whatever confidence they still have in the financial results reported by banks.
The correct way out of this problem is not to change the accounting rules, but to look at temporarily easing aspects of their consequences, e.g. in the capital adequacy rules.
Yesterday's news may be seen as an unimportant detail, not worthy of more than a small article in the FT, but it will likely be the start of a dangerous trend.
