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Regulation - January 20, 2009

International investors doubt the effectiveness of the accounting standard amendments in attenuating the financial crisis

The current credit crisis, triggered by losses on American subprime mortgages, has gradually turned into a global crisis of confidence. In October 2007, G7 finance ministers and central bank governors asked the Financial Stability Forum (FSF) to examine the causes of the crisis and make recommendations for managing it.

Some of these recommendations (FSF 2008) dealt with accounting standards. The FSF recommended that these standards improve the treatment of off-balance-sheet items (for greater transparency), that they offer more guidance on the pricing of financial instruments in inactive markets, and that they require better information on pricing methods and on their sensitivity to the assumptions and parameters chosen.

Fair value debate

In this context, then, a debate about the appropriateness of fair value accounting in times of crisis sprang up. This lively debate reflects, as it happens, the difficulty of valuing both complex and conventional financial instruments in inactive markets.

As the crisis worsened over the summer of 2008, the shoring up of the banking system and the protection of depositors became priorities. Governments worldwide intervened, and on 22 September the group of G7 finance ministers requested that the FSF recommendations be put into practice.

At the same time, the number of critics of fair value accounting has continued growing. They accuse it of being one of the causes of the amplification of the crisis. The two major grounds for complaint are its pro-cyclical nature and the insufficient information provided by the standard-setting bodies on the means of valuing financial instruments in inactive markets.

Their backs against the wall, the FASB and the IASB raced to make amendments to their standards. On 30 September 2008, the SEC and the FASB issued additional guidelines for valuing assets in inactive markets (US SEC 2008). On 16 October, the European Commission (EC regulation 1004/2008) adopted the IASB’s amendments to IAS 39 and IFRS 7.

The aim is to allow financial institutions (mainly banks) to lessen the impact of the current crisis on the accounts published as of the third quarter of 2008. For this purpose, the IASB is, on certain conditions, allowing certain financial instruments— loan-related securities among them—to be shifted to classifications for which the accounting treatment results in absence of volatility in the profit and loss account and perhaps even in the balance sheet (with the exception of durable depreciation).

Call for reaction

A “call for reaction” was sent by EDHEC to international institutional investors and asset managers to compare investor views of the amendments to the IAS39 and IFRS 7 standards not just with the conclusions of an initial EDHEC study ("The Fair Value Controversy: Ignoring the Real Issue"), but also with the ambitions of these reforms prepared and adopted in great haste.

The call for reaction received more than 800 responses and represents the first international survey on the relevance of the reforms carried out by the IASB under pressure from the European Commission. The results of this study - entitled "Reactions to an EDHEC Study on the Fair Value Controversy" - correspond to EDHEC’s initial arguments. Fewer than a quarter of the respondents believe that these amendments are necessary and well suited to resolving the problems of bank solvency. Moreover, three-quarters of respondents believe that they are likely to lead to new problems.

If many critics are arguing that fair value is partly to blame for the spread of the crisis, especially as a result of its pro-cyclicality, the EDHEC study shows on the contrary that this debate is biased because it is off target. Indeed, when the problem is analysed farther upstream, it becomes clear that the amendments to the standards are counterproductive. By making it possible, under certain conditions, to report at historical cost transactions that had previously been reported at fair value, these amendments reduce the amount of information contained in financial reporting. These changes are likely to hide the real risks to which companies are exposed and to increase the mistrust of the financial community. In addition, only 44.2% of those who respond to the call for reaction think that these amendments are likely to reduce pro-cyclicality.

Even if fair value accounting leads to a cyclical weakening—justified by the crisis—of the fair value of the equity of financial institutions, it is not the accounting standard setter’s job to estimate the amount of additional capital needed or to call for a curtailment of business activity. That is the role of the prudential regulators.

These two publications nonetheless show that the measure of fair value and the choice of accounting treatments made by the IASB are highly debatable but do not necessarily mean that fair value accounting itself must be rejected. EDHEC even considers that a return to accounting at historical cost would be mistaken; it would only prolong the crisis, much as it prolonged the Japanese banking and financial crisis. 28.1% of the respondents also think that the amendments could worsen the crisis by making financial information less trustworthy.