Via Martin Varsavsky, I find a WSJ article where Steve Forbes gives a provoking view on the roots of the Banking Crisis. Mark-to-market or “fair value” accounting for financial institutions was re-established in 2007 in USA. The Financial Accounting Standards Board (FASB) rules that the balance sheet must reflect the “market” value of the financial assets.
With the market value of financial assets falling after the system credibility crisis, banks are dragged close to bankruptcy only due to the need to account for assets at today’s market valuation.
Quoting Mr. Forbes:
Regulatory capital by its definition should take the long view when it comes to valuation; day-to-day fluctuations shouldn’t matter. Assets should be kept on the books at the price they were obtained, as long as the assets haven’t actually been impaired.
Mark-to-market accounting does just the opposite. When times are good, it artificially boosts banks’ capital, thereby encouraging more investing and lending. In a downturn it sets off a devastating deflation.
Mark-to-market accounting is the principle reason why our financial system is in a meltdown. The destructiveness of mark-to-market — which was in force before the Great Depression — is why FDR suspended it in 1938. It was unnecessarily destroying banks.
And a proof point of this thesis can be that while American banks like Citibank are near-bankrupt, other banks in Europe like Santander, less exposed to American accounting rules, seem healthier even though the fundamentals of Spanish economy are much worse than in US.
Markets are so volatile that the idea to use them for accounting is a recipe for system instability.
Take Santander stock price as an example. Why Santander PER is currently 4 (with a 11% yield), when during last 7 years it had always been above 20, with a mere 2% yield? Which valuation is “fair” for accounting? the one of last 7 years? or that of last 7 months? Isn’t the valuation just reflecting how optimists or pessimists are investors? should “optimism” be accounted in the books??
Economics is far from exact science, and it is remarkably incapable of predict, sometimes even explain a posteriori, events such as the current crash. What we know from economists is that people expectations are the most reliable indicator to predict the growth or slow down of economic activity. The credibility of the financial system is now below limits. Fear (panic) to a banking system collapse is reducing consumer spending, companies forecasts are revisited and unemployment surges as companies prepare for the downturn. A vicious circle that the accounting rules strangely help accelerate.
An accounting system based in market valuations, under the current gloom, makes the simple possibility of bankruptcy a self-fulfilling prophecy.