Bankers: Fair value is like throwing gasoline on a fire Case study Help
ABSTRACT
The debate between proponents of the fair value measurement system and those who oppose it tooth and nail is a long standing one. While there are logical arguments in support of the system, there are others which question its relevance and reliability in certain situations. There are instances where anomalous situations are created if the fair-value system is used, but there are also cases where historical cost method leads to “less-than-transparent” financial statements. This paper examines the reasons for opposition to the fair value system by the Bankers, and the counter arguments of the FASB in support of the system. It is noted that different industries have idiosyncrasies related to their assets and liabilities, and hence the effects of application of any valuation method can vary. It is concluded that the fair value measurement system should ideally be used for all assets & liabilities for banks. However, in certain cases (e.g. loans), where it leads to exaggerated or inaccurate values, historical method can be used. In such cases, the result of fair value measurement can be an additional disclosure, and should not be allowed to affect the income statement or the capital or the statutory ratios.
INTRODUCTION
The opposition by bankers to the use of fair value measurement system is based on some peculiarities related to the nature of their assets and liabilities. The bankers consider the mixed-attribute system as a better method of valuing assets (e.g. loans) as it is more representative and predictive of values. FASB considers the fair-value system to be better, and contends that even for loans, the old “originate and hold” model has been replaced with the “originate and distribute” model (Leone 2008). The differences in opinion are understandable as both sides intend to further their respective objectives. While the ultimate goal of both may be same, viz. a more representative balance sheet, the preferred approaches to valuing assets and liabilities are different. While examining the arguments of both sides, the pros and cons of the various systems have been discussed by referring to insightful articles and case studies from varied sources.
- What are the most controversial features of the ‘Fair value’ accounting as laid out in FAS 159 The Fair Value Option for Financial Assets and Liabilities, International Accounting Standards Board’s (IASB) IAS39 Financial Instruments: Recognition and Measurement, and FAS157 Fair Value Measurement that the banking sector is concerned about? (8 marks)
Answer 1
Prior to delving into the controversial issues relevant to the banking industry, it is important to understand what these standards attempt to address.
FAS 157 – Fair Value Measurement
The Statement defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles (GAAP), and expands disclosures about fair value measurements (FASB 2006). The statement attempts to bring consistency and comparability in fair value measurements.
FAS 159 – The Fair Value Option for Financial Assets and Liabilities
The Statement permits entities to choose to measure several financial instruments and certain other items at fair value. The objective is to improve financial reporting by providing entities with the opportunity to reduce volatility and improve uniformity in reported earnings, without having to apply complex hedge accounting provisions (FASB 2007).
IAS 39 – Financial Instruments: Recognition and Measurement
This standard from IASB also gives a fair value option similar to IAS 159, but the option is subject to certain qualifying criteria, and applies to a slightly different set of instruments. It outlines the requirements for the recognition and measurement of financial assets, financial liabilities, and some contracts to buy or sell non-financial items (Deloitte 2009).
‘Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (FASB 2007 para 5).’ The techniques of valuation include Market, Cost and Income approach (or a combination of these) (FASB 2007, para 18). The “price” can be based on three levels of inputs (level 1, 2 & 3) available from various sources, and the judgment exercised by the valuers (FASB 2007, para 24, 28 &30). The levels are to be used in this particular order of preference (Miller & Bahnson 2007). As per IASB (2011), this hierarchy of inputs is required to increase consistency and comparability in fair value measurements and related disclosures.
While most people agree that FVM is appropriate for financial instruments held for trading purposes, there is controversy regarding its use for the assets and liabilities intended to be held to maturity (e.g. loans, deposits and receivables). Particularly for the banking sector, it is contended that the expected cash flow from loans given to customers will not be represented properly, and it could lead to less predictive value. Also, in case of a write down due to deterioration in the quality of such receivables, the frequent impact on the net income would make the earnings unduly volatile (Leone 2008).
Another example of an anomalous situation would be where there is a deterioration in the creditworthiness of the bonds issued by a bank leading to a “reduction” in liability. This would be a “profit” for the bank in the income statement (when the creditworthiness declines!). The reality, however, is that the bank still owes the full value of the bonds to the holders, and the “profit” is not realizable that easily. In many cases, “value changes” may be the difference between rejected hypothetical opportunities (Rayman 2004).
In some cases, banks are allowed to route the write downs through “Other Comprehensive Income”, which helps them hide the impact of legitimate write-downs on the income statement. Furthermore, the leeway given by the standards, to apply FVM instrument by instrument, also makes the field less level, and increases chances for opportunism in accounting (Keoun 2008). All this can make the balances sheet less representative of the true and fair value of the state of affairs of the firm.
Banks prefer a mixed attribute model, where both fair value and historical costs are used (Leone 2008). Banks contend that FVM will lead to a less reliable method of estimating the quality of the assets and liabilities. During financial crisis, when bank needs the capital the most, this may add to the problems by erosion of capital (Talley 2010).
However, there have been several voices in favor of the FVM system stating that it leads to faster recognition of adverse events, and provides insights into how senior managers view the quality of the assets (Katz 2008). As stated by Ryan (2008), the mixed-attribute model can prompt accounting-motivated transaction structures.
The differences in opinions mentioned above, lead to controversy about these standards.
- The American Banking Association (ABA) Chairman, Edward Yingling claims, “under the stress of current market conditions, accounting policy accounting policy should focus on measuring the heat of the flame instead of pouring gasoline on the fire.” What does he mean “heat of the flame”, and “pouring gasoline on fire”? Why did he making such a strong comment? (8 marks)
Answer 2
While fair value measurement (FVM) system may yield the desired results in other sectors of the economy, its applicability to the banking sector sometimes leads to anomalies and undesired consequences. Some of these peculiarities may have prompted Yingling to make such a strong comment. By “heat of the flame” he means that the idea should be measure the quality of the assets & liabilities of the bank using a reliable and relevant method. The “Pouring gasoline on fire” comment underscores his belief that use of FVM could lead to aggravating or exaggerating a negative situation (e.g. lower creditworthiness, lower quality of some assets) for a bank. Sometimes, these changes may be temporary, and consequences of altering the financial statements based on these swings may lead to worsening of the situation. The following paragraphs explain some of these concerns.
The quality of the assets and liabilities of a bank are indicative of the overall health of the economy. In case a bank’s assets & liabilities are valued periodically using the FVM system, then the earnings may be more volatile compared to when historical cost method is used. The write downs will lead to reduction in capital of the banks, or lower book values (if the other comprehensive income route is taken), making them less aggressive in lending. Further, the write downs may aggravate the negative outlook towards certain banks, which may lead to cascading negative effect on its credit rating and ability to obtain funds from the market. This worsens a “bad situation”, and may spiral the bank into deeper trouble. In fact, the requirement of bank credit is the maximum during a financial crisis (Talley 2010). Some of the changes in fair value may be temporary, and many of the responsible factors may not be in control of the management, or reflective of the performance of the bank. Even the bankers agree that while the impairments should be written down, fair value should not be applied to the other assets & liabilities for the above mentioned reasons (Leone 2008).
Then there is the question of relevance of FVM for some specific assets or liabilities e.g. loans. Writing down assets due to temporary fluctuations may misrepresent the cash flow potential of the asset (Leone 2008). On the other hand, a deterioration in value of a bank’s bonds (due to lower credit rating) may lead a “profit” in the books. Actually, the bank still owes the full amount to the lenders, and cannot sell off the liability easily to realize the “profit” (Keoun 2008).
The question of reliability of the fair values is also pertinent. While level 1 values are obtainable for a percentage of assets, for the rest, the less objective level 2 & 3 inputs are used. Specially for loans, which are a major part of the bank’s assets, a liquid market does not always exist. For example, 64% of the financial instruments of the Commonwealth Bank of Australia were measured using level 2 inputs (CBA, 2012, p. 212).
Further, there are studies which indicate that net historical loan costs are generally a better predictor of credit losses than loan fair values (Cantrell, McInnis, Yust 2011).
The above mentioned issues & arguments may have been more true and relevant in 2008, and Yingling’s strong comments reflect the sentiments at that time.
- The ABA Chairman also labeled the accounting standards requiring fair value measurement for financial instruments as, “a step in the wrong direction.” What are his arguments for making such comment?(4 marks)
Answer 3
As mentioned by Leone (2008), the ABA Chairman contends that full fair value measurement is appropriate for financial instruments held for trading purposes. For other assets held to maturity (e.g. loans, deposits, and receivables), the fair value measurement (FVM) may lead to volatility in the income statement of the bank. The bankers prefer a mixed-attribute model (both fair value and historical cost method).
Specifically for loans, which are the main assets for banks, the bankers state that they are held to generate income via receiving interest, and held for maturity. The expected cash flows and their impact on the income statement are known, and the assets and liabilities are recorded at amortized cost. The amortized cost provides the required information to the investors about the loan. In case the FVM is used, the updation of the values of the loans from time to time will lead to less predictive results, as the future cash flows will not always be represented. The bankers are also questioning the usefulness of the fair value measurement when it lacks relevance and reliability. Yingling contends that instead to reflecting the true and fair values of the assets, the related write-downs would lead to aggravating the problems for the bank by worsening the outlook for the bank.
