Fisher Investments Editorial Staff
Market Risks

Marking to Footnote

By, 05/16/2011

Story Highlights:

  • An accounting rule change proposal was made formally Friday that would move a step further away from the disastrous aspects of FAS 157.
  • This should help resolve the debate over fair value accounting standards, but other aspects seen as contributing to 2008’s financial panic remain open for discussion.
  • Regulators are busy trying to determine which banks pose “systemic risk” and which do not.
  • Tellingly, some banks are lining up to say they’re small enough to fail.

Friday was a busy financial news day, with headlines dominated by better-than-expected eurozone GDP and slowing US CPI (i.e., inflation). But quietly, the Financial Accounting Standards Board (FASB) announced a proposal to adopt the International Accounting Standards Board’s (IASB) version of fair value requirements.

It might seem a bit out of character for accountants to make a noisy to-do about a rule change, but this strikes us as significant. The proposal represents a further step away from (and could essentially sound the death knell for) problematic aspects of FAS 157—the well-intended accounting principle that significantly contributed to 2008’s financial panic before losing much of its teeth following March 2009’s congressional hearings on the subject.

For some time now, discussion over merging US and international accounting standards to “harmonize” rules has occurred—a fine idea, but one also raising the possibility of FAS 157-like policy being reborn. After Friday, that’s still possible—but seems extremely unlikely. (We’re not superstitious, but we just knocked on wood.) If the rule is adopted as proposed, banks will still be required to report the fair value of assets held. But mark-to-market values for less-liquid assets intended to be held to maturity will be reported in footnotes (as they are, thankfully, today). This is vastly different than the period from November 2007 through March 2009—when banks were, disastrously, forced to give equal treatment to very dissimilar assets. This proposal, which the IASB and many banks support, should satisfy most seeking transparency, but is more measured—so bank balance sheet health won’t hinge on the immediate liquidation values of illiquid assets. While this decision should help resolve the fair value debate, other heavily discussed aspects of the panic still await resolution.

For one, regulators are busy trying to determine which banks pose “systemic risk” and which do not. In fact, many banks are arguing they’re small enough to fail—which some might see as odd (that is, if you assume corporations might want some sort of government backstop against their failure), but not if you consider 2008’s actual events.

Was the problem really all about some banks’ sizes, or was it more that investors couldn’t figure out the government’s next steps? Consider: Lehman Brothers and Bear Stearns were roughly the same size and type of institution—yet the government took entirely different paths in dealing with them (not to mention other troubled firms). The result? Widespread uncertainty leading to even greater credit- and equity-market volatility.

Some banks now seemingly think if they’re designated systemically insignificant, investors still have to ponder potential bankruptcy risk—but not handicap regulators’ schizophrenic actions. Being small enough to fail also removes those banks from potentially stricter government regulation, fees and oversight the “Too Big to Fail” (TBTF) banks could receive—which could expose TBTF firms to more subjective regulation ahead. Of course, the flip-side could also be true: TBTF banks could be a competition killer as customers flock to banks perceived to have an extra government security blanket. But these small- and mid-size banks wanting to avoid TBTF designation evidently see greater benefit in avoiding potential future government involvement.

Evenly applied, well thought-out regulation is a clear plus, but the government’s actions in 2008 don’t meet that definition. The financial panic was seriously exacerbated—if not initiated—by a series of regulator choices showing close to zero consistency or understanding of potential unintended consequences. No doubt, weak housing and credit market displacements played roles, but absent misapplied accounting rules and haphazard government responses, the crisis likely wouldn’t have been so steep and deep. Folks, 2008’s panic cannot be simply explained by claims it was the inevitable byproduct of banker greed run amok, “toxic” assets, wealth inequality or subprime and/or housing market woes. Those might be easy explanations to deliver and comprehend—and they largely exonerate regulators from blame—but they simply don’t fit the facts, nor do they provide investors with insight helpful in obtaining a sense of closure.

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*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.

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