Financial institutions should provision to cushion impact of business cycle fluctuations on balance sheets (photo: Robert Cohen/St Louis Post-Dispatch)
GLOBAL FINANCIAL STABILITY REPORT
It is rare that an arcane accounting principle becomes the subject of public debate. But the role of fair value accounting (FVA) in the financial turmoil that began last year in the U.S. subprime mortgage market has come under "close scrutiny," the IMF noted. Some critics allege that it made matters worse, increasing volatility and amplifying the effects of the business cycle on the net worth of financial institutions and adding to the uncertainty about how accurately institutions could price some of their illiquid assets.
Transparency of FVA
But the IMF concluded in the October Global Financial Stability Report that the FVA approach, which seeks to value assets and liabilities at prices reflecting current market settings, ensures the most accurate assessment under most conditions.
The IMF acknowledged the application of FVA can exacerbate procyclicality of bank balance sheets and suggested some approaches to mitigate the impact. However, under some applications, FVA has the potential to reduce procyclicality. On balance, the IMF said, with some enhancements, FVA is "the preferred accounting framework for financial institutions."
The Fund said that FVA is more transparent than alternative methods and that financial institutions and regulators could take steps to reduce the procyclical effects of FVA. Some of the problem lies not with the FVA framework itself, but with how financial institutions use it in their decisions and risk management, the IMF said.
Determining value can be difficult
But determining the current value of a balance sheet can be difficult. As a result, balance sheets are often valued using a mixture of approaches.
In estimating fair value for assets (or liabilities) that are traded regularly in public markets—such as stocks, bonds, or treasury securities—current price quotations are available. Value is determined at those prices, or "marked to market."
However, not all assets or liabilities are publicly traded. If there are comparable instruments, institutions can refer to them to estimate the value of their own portfolio.
But when there are no public or comparable price quotes, as for many of the instruments that triggered the current turmoil, financial institutions have to rely largely on judgment, using models to take into account relevant economic and market data. In "marking-to-model," during recent stressed liquidity conditions "financial institutions made wider use of unobservable inputs in their valuations," and the less transparent the valuation, the greater the uncertainty about their accuracy.
Widespread uncertainty
It was widespread uncertainty about the incidence and value of a large number of securities that contributed to the seizure of many markets and the sharp contraction in market and funding liquidity.
To assess FVA's strengths and weaknesses, the Fund used representative balance sheets from a sample of actual institutions to examine empirically whether the application of FVA can introduce unintended volatility and amplify procyclicality of balance sheets. For example, when institutions sell assets with declining values to shore up their balance sheet and it has the unintended consequence of further driving down the asset values and further weakening balance sheets.
Using the latest shocks to the financial system and economy as examples, the analysis found that FVA can cause wider swings than other valuation methods, but that there are some options that have the potential to mitigate procyclicality. Some types of banks are more affected than others, depending on the nature of the assets and liabilities they carry on their balance sheets and how they apply FVA to them.
What to do
The IMF suggested that financial institutions should take such steps as:
• Selectively adding information about how they value assets and liabilities.
• With regulators' support, strengthening capital buffers and provisioning to cushion the impact of business cycle fluctuations on their balance sheets.
• Issuing shorter, more focused accounting reports targeted to specific audiences at a higher frequency than they do now.
Comments on this article should be sent to imfsurvey@imf.org
