Prior to the crisis, banks (and regulators) did not complain about mark-to-market accounting for complex products with embedded derivatives, as markets rose, volatility declined, spreads narrowed and profits were booked. Problems arose immediately after the crisis, once the process reversed and asset impairment had to be taken as losses (large enough to overwhelm the capital of some financial conglomerates). At the heart of this matter lies the issue of how to value complex financial assets. As the crisis deepened, the applicability of ‘fair value’ or ‘mark-to-market’ accounting to assets for which no liquid markets exist was reviewed by IASB and in the USA by the FASB.
Accounting standards are set to ensure that investors and creditors of firms have clear information. Financial reports need to be reliable, understandable and comparable between companies and across jurisdictions. This includes all off-balance-sheet entities for which banks are exposed to loss, and the correct accounting for securities valued at fair value through profit or loss versus those to which amortised cost accounting might apply. This is important to maintain the confidence of investors in public markets and to help reinforce shareholder discipline on management. The manipulation of earnings by allowing firms to book mark-to-market gains in the good times but to hide losses when things go wrong is inconsistent with these goals. IASB has reviewed the liquidity issue extensively and IFRS 9 made some basic changes:
Debt instruments that are not held for trading purposes may be measured at amortised cost (even if listed).
Equity instruments only have to be measured at fair value through profit or loss if they are to be traded. If they are not, the firm has a choice between the fair value approach and a method that does not require impairment charges to be taken to profit or loss.
Similarly, FSP FAS 157-e applies since June 2009, allowing banks more judgement in determining whether a market is not active and a transaction is not distressed when discounting future cash flows of assets held to maturity (as opposed to the fair market price at the time).
The above changes allowed banks to reclassify some loans, essentially when the intrinsic value of assets is judged by management to exceed their estimated fair values, due to significantly reduced liquidity, and returns would be optimised by holding them as hold-to-maturity investments—essentially reclassifying from financial assets at fair value through profit or loss to loans where amortised cost methods would apply. Allowing firms too much scope to switch impaired fair value assets to amortised cost accounting categories—reclassifying a complex structured product with imbedded derivatives as a loan for example—because it suits the bank in the short run is inconsistent with sound long-run objectives. Transparency is very important.
Policy makers from some countries in Europe and the European Commission suggested at the time that the above changes didn’t go far enough—they were concerned that applying the rules would make French and German Landesbanks look worse. Jörgen Holmquist, director general of Internal Markets at the European Commission, argued in a letter to IFRS that more assets might be marked to market under the new system than even under existing rules. He urged the IASB ‘urgently’ to consider further changes. A letter to Commissioner McCreevy from Ernst and Young, 9 November 2009, refers to an internal French report that suggests Europe may need to establish its own standard setter if demands for even further changes than in IFRS9 are not met. Markets require transparent and material information, so that the discipline on management can be maintained. Furthermore, accounting standard setters need to be free from this sort of pressure as they continue to work on bringing about the much needed convergence of FASB and IFRS.