Financial crisis not fueled by fair-value accounting

Financial crisis not fueled by fair-value accounting

Fair-value accounting, also known as “mark-to-market” accounting, has been blamed for contributing significantly to the financial crisis. But those charges are largely unfounded, according to the study “Did Fair-Value-Accounting Contribute to the Financial Crisis?” by Christian Laux of Goethe University Frankfurt and Christian Leuz of University of Chicago Booth School of Business, which is forthcoming in the Journal of Economic Perspectives, published by the American Economic Association (http://ssrn.com/abstract=1487905). In their study, Laux and Leuz analyze the role of fair-value accounting for US banks and conclude that there is no evidence that fair-value accounting added to the severity of the recent financial crisis in a major way.

Drawing the right conclusions about the role of fair value accounting in the crisis is important given the current debate about financial reform. Recently, the Financial Accounting Standards Board announced a proposal to tighten fair-value accounting, which would lead to more instruments being recognized at fair value on the balance sheet. Many in the financial sector, by contrast, have pled for more relief from fair-value accounting, arguing that it caused problems in the crisis. Lawmakers in Congress have also taken a keen interest in this issue.

The main allegations against fair-value accounting are that it contributes to excessive leverage in boom periods and leads to excessive write-downs in busts. The write-downs due to falling market prices deplete bank capital and set off a downward spiral, as banks are forced to sell assets at “fire sale” prices. Mark-to-market accounting can then lead to contagion as prices from asset-fire sales of one bank become relevant for other banks. These arguments are often taken at face value and evidence on problems created by fair-value accounting is rarely provided.

A major problem in the crisis was that banks were highly levered during the boom and relied heavily on collateralized repurchase agreements. However, as Laux and Leuz discuss in the paper, it is unlikely that fair value accounting contributed to bank leverage prior to the crisis. The amount of debt that can be obtained by collateralized borrowing depends on the market value of the assets used as collateral (not the book value set by accounting rules). Investors were concerned about banks with substantial (subprime) mortgage exposure once the problems in the mortgage market were apparent. Thus, financial institutions that relied heavily on short-term borrowing and had substantial subprime exposures would have faced major difficulties regardless of the accounting rules. In fact, less transparency about losses and exposures could have made matters worse.

In making their case that contagion effects of fair-value accounting did not play a major role in this crisis, Laux and Leuz point to the following reasons. First, for U.S. bank holding companies, the impact of fair-value changes on the bank income and regulatory capital (in booms or busts) is much more limited than the vigorous public debate might suggest. The majority of assets, in particular loans, are not carried at fair value on the balance sheet. But even for assets that are carried at fair value, not all fair value changes affect banks’ net income or enter the computation of the banks’ regulatory capital. Second, the treatment of financial assets under US accounting standards (GAAP) is more flexible than is often known. Laux and Leuz stress that the accounting rules allow reported values to deviate from market prices under important circumstances. For instance, fire-sale prices are not supposed to be used in determining fair value. The standards also allow banks to deviate from dealer quotes and to value assets using cash flow models using unobservable inputs (Level 3 assets) as markets for these assets become illiquid. Thus, the argument that fair-value accounting forces banks to mark to market asset prices under all circumstance and even when prices are distorted is misleading. In other words, current fair-value accounting rules contain several “circuit breakers.”

The obvious next question is whether banks used these safeguards in the financial crisis. Using US banks’ financial statements, Laux and Leuz provide evidence that, as the crisis deepened, banks made ample use of the flexibility built into the rules. For instance, they moved assets that had been valued using quoted prices in active markets (Level 1 assets), or that had been valued using observable inputs from similar assets (Level 2 assets), to Level 3 valuing them with models. For many banks, this switch from “mark-to-market” to “mark-to-model” occurred early in the financial crisis. For instance, banks with substantial real-estate exposure and large trading portfolios used cash-flow-based models to value their mortgage-related securities by the third or fourth quarter of 2007. The notion that pure marking to market was widespread among U.S. banks is simply a myth as far as mortgage-related securities are concerned.

There also seems to be little evidence of excessive write-downs, or that fair values reported by banks were systematically too low. Laux and Leuz point to a number of studies that compare banks’ reported fair values of assets with the market prices of those assets, to find out whether fair-value accounting forced banks to report figures that were artificially low. A consistent finding in these studies is that investors priced a dollar of reported assets valued using models (Level 3 assets) significantly below a dollar of reported assets valued by quoted prices in active markets (Level 1 assets). This finding suggests that the use of “mark-to-model” accounting allowed banks to report Level 3 asset values that are too high compared with investors’ valuations, rather than too low. On the whole, the evidence presented by Laux and Leuz suggests that, far from being a main contributor to the crisis, fair-value accounting rules actually allowed banks to use discretion to keep fair values high. Rounding out the analysis, they point to similar evidence for other assets on banks’ balance sheets, notably loans and goodwill.

While the claim that fair-value accounting exacerbated the financial crisis appears to be largely unfounded, Laux and Leuz point out that their findings need to be interpreted cautiously. They are not advocating an extended use of fair values. It is possible that the role of fair-value accounting was limited precisely because its relevance for banks’ balance sheets and capital requirements was limited. Having said that it is important for the reform debate to recognize that even if (stricter) fair-value accounting were to contribute to downward spirals and contagion, these negative effects in times of crisis have to be weighed against the positive effects of timely loss recognition. Lenient standards may help to avoid contagion effects in times of crisis, but relaxing the rules and giving bank management flexibility in interpreting fair-value accounting standards opens the door for manipulation. This can have negative effects before a crisis hits. Making banks recognize losses early on forces them to take steps to fix problems quickly, and may even encourage them to be more cautious in the first place. Thus, standard setters face many thorny tradeoffs, which are discussed in greater detail in a companion paper, “The Crisis of Fair-Value Accounting: Making Sense of the Recent Debate,” that appeared in Accounting, Organizations, and Society in 2009 (http://ssrn.com/abstract=1392645).

 Click to View Entire Study