Fair Value Accounting and Procyclicality: Regulatory Challenges

1. Fair Value Accounting and Procyclicality: Regulatory Challenges Christian Laux Vienna University of Economics and Business & Center for Financial Studies (CFS) CEPR Conference “The Future of Regulatory Reform” 4th October 2010, London

2. Prefix: What is Fair-Value Accounting (FVA)? • FV = Price that would be received to sell an asset in an orderlytransaction between market participants • Explicit restriction: It is not a price from a distress or fire sale • FVA in its pure form = reporting assets at FV on the balance sheet and recognizing changes in fair value as gains or losses in the income statement • Different levels of FVs depending on the inputs (US GAAP) • Level 1: Market price for same asset  pure marking to market • Level 2: Prices for similar assets and observable inputs for models • Level 3: Predominantly unobservable inputs for models

3. Fair Value Accounting and Procyclicality • FVA has been blamed to have exacerbated the financial crisis • Excessive leverage in booms • Excessive write-downs in busts • Downward spirals: declines in asset values  write-downs  fire sales, further declines, and further write-downs • Contagion: Fire sales become relevant “marks” for other banks • Major policy debate and intense pressure on the standard setters • Arguments about the problems are often taken for granted, but: • Specific evidence of the problems is rarely provided • Instead references to various models, but they model full FVA and not the accounting system that is currently in place

4. FVA and US Banks • Laux and Leuz (JEP 2010) do not find evidence supporting claims that FVA contributed to the crisis in a major way (or that HCA would have been better) • FVA plays a limited role for most bank assets • “Full FVA” only applies to trading assets • Unrealized FV changes of available-for-sale (AFS) securities only affect shareholders’ equity, not income • Loans (including mortgages) and held-to-maturity securities (HTM) are reported at amortized costs • For most BHCs, loans constitute over 50% of the balance sheet • Banks made ample use of discretion in FVA • For over 75% of the FVs, US banks use models (rather than prices directly) • Little evidence that banks were forced to excessively write-down assets (for some assets the opposite is likely true) • Adjustments are made for regulatory purposes (prudential filters) • Unrealized losses of AFS debt securities do not reduce regulatory capital

5. A Note on FVA and European Banks • Was the situation different in Europe? • FVA under IFRS is similar to US GAAP • Several commercial banks in Europe with high fraction of trading assets (including repo agreements) • 72% for Deutsche Bank (2005/2006) • Differences in prudential filters (relative to US and within EU) • Unrealized losses of AFS debt securities did reduce regulatory capital in some countries, e.g., Germany and Italy • Played a big role for some German Landesbanken • Considerable pressure on standard setters to relax FVA rules • Reclassification allowed in Oct. 2008, e.g., reclassify non-derivative assets from trading assets or AFS securities into the loans and receivables category • Strong disclosure requirements for reclassified assets • But effect on regulatory capital for reclassified trading assets • In addition, also an effect for AFS debt securities in Germany and Italy

6. Policy Issues and Regulatory Challenges • Why is FVA so disputed? • Understand the problems to defend FVA against the interests of different constituencies • Disentangle self-serving arguments from real arguments • How to improve FVA? • Understand costs and benefits of FVA (compared to HCA) • What are the main problems of (implementing) current FVA standards? • Which circuit breakers were most important and how were they used? • Should the use of FVA be extended? • Just because there is little evidence in the financial crisis does not mean it could not be a problem • Can accounting and prudential regulation be separated? • Benefits of transparency without the cost of procyclicality?

7. Why is FVA so disputed? • It is easy to confuse problems stemming from the use of market prices for private contracting with problems stemming from their use in accounting • E.g., short-term financing / repurchase agreements are based on market prices; haircuts and margin requirements have a strong procyclical effect • Accounting rules involve many tradeoffs • E.g., timeliness, relevance, reliability, consistency • Different users may have different objectives (costs and benefits) • The optimal trade-off may differ for different asset classes, periods, and business models • It is always possible to find an argument against an accounting rule • “Personal” interests of users • Flexibility of HCA: gains trading and accumulation of hidden reserves • Regulatory forbearance • Shifting attention (and blame)

8. Should FVA be extended? • Two opposing groups when it comes to extending the use of FVA: • Proponents stress transparency and market discipline • Opponents focus on market distortions and excess volatility • The position depends on the • Level of trust in the market, models, and management • The underlying view about the role of accounting • “Personal” interests • When FVA is extended to illiquid assets, it looses many of its desired properties as models have to be used • Focusing on credit risk, the main difference between full FVA and HCA would amount to when impairments have to be recognized • There may be problems with FVA but timely impairments facilitate prompt corrective actions • Tradeoffs (in a crisis but also with respect to ex ante incentives) • HCA may have even bigger problems

9. Potential Issues (An Example) • Full FVA is not disputed for liquid assets held for trading • What about illiquid assets that are held until maturity? • FV is the price that would be received to sell an asset • For illiquid assets, this price may be considerably lower than the present value of expected cash flow if held to maturity (in particular, in distressed markets) • There are three alternatives for illiquid assets that are held until maturity • They can be treated in the same way as liquid assets held for trading • FV can be defined differently for the two types of assets • FVA can differentiate FV changes due to changes in (a) credit risk and (b) changes due to other reasons (e.g., illiquidity) • Should (b) affect shareholder equity? • Does it matter? -- Prudential filters, accounting fixation?

10. Potential Issues (Example cont.) • Should management be allowed to reclassify assets if the intent changes? • Reclassification reduces problems for the bank • But even without a loss in transparency, reclassifications may have detrimental ex ante incentive effects

11. Separating Accounting and Prudential Regulation? • One link through which FVA can have a procyclical effect is trough capital regulation • Can this link be broken by introducing prudential filters (rather than sacrificing accounting transparency)? • Prudential filters are in place for AFS debt securities in many countries • In the crisis, many large banks had refinancing problems due to the prevalence of short-term financing and repo agreements • It is unlikely that reporting FVs exaggerated the refinancing problems • Refinancing problems started well before losses were reported • There was huge uncertainty in the market about the value of the assets and counterparty risk • If anything, it seem that there was not enough information about exposures • Market reacted very negatively to concerns that banks were not “honest” about their exposure and losses • It is unlikely that HCA would have calmed the market

12. Key Assets on Balance Sheets of U.S. Banks Laux and Leuz (JEP 2010)

13. Key Rules