Accounting changes across the EU in 2005 not only allowed banks to under-provide for loan losses but also brought in mark to market (MTM) for valuing financial assets and liabilities, including financial instruments.
Mark to market is rooted in the efficient market hypothesis, a theory that financial markets are a good indicator of rationally evaluated economic value; the risks in markets can be inferred from mathematical analysis; and markets themselves can act to constrain harmful risk taking.
Many academics do not accept this theory in its undiluted form, because it ignores the impact of human behaviour, and in particular, the herd instincts of the greedy who blow up market bubbles in the hope of making a quick buck before the bubble bursts. It encourages short- termism in investment.
MTM is not new. For example after the great US crash in 1929, MTM was abandoned and accounting reverted to historical cost to value financial assets. Historical cost is claimed to be the only other way of valuing assets but there is another method which deserves consideration i.e. deprival value – the lower of cost or the recoverable amount of an asset.
In the recent banking crisis MTM came back with a vengeance, because in a deep and liquid market neither companies nor auditors have to value financial assets as price is the equivalent of value. MTM can work in a stable market but is less reliable for accounting purposes when markets bubble as inflated prices feed a bubble.
MTM was used in the UK before 2005, but crucially under a regime which required directors and auditors to consider whether company accounts were prudently compiled and showed a true and fair view overall.
Under the 2005 rules, if a financial institution is holding assets in a trading book and marking them to market in a rising market, the increase in price is treated as a realised profit without a sale.
This profit, however, is not a cash or near cash realisation, but bizarrely can be used to pay bonuses, creating incentives for the greedy to keep their assets in a trading book, sit back and watch the “fantasy” profits come rolling in. A key unresolved problem is to what extent such “fantasy” profits are available to pay dividends as well as bonuses.
Accounting regulators in the UK, after seven years of this accounting regime , have yet to address the conflict between UK company law and accounting rules about what is a realised profit and what can be used to pay dividends. It is unlawful to pay dividends out of capital or to make payments which render the business insolvent. But what should happen if the accounting rules themselves legitimise false profits?
Accounting for financial instruments presented an even greater problem. The accounting gurus decided, possibly under pressure from the banking sector, that the only way to value some of their traded complex financial instruments was by marking them to market.
This decision was taken when the markets were relatively stable and boom and bust was allegedly at an end. Added to the accepted volatility risk of MTM was the lack of deep and liquid markets to provide a price, let alone a value for some of these instruments. So many were marked to models, devised by the banks themselves, or in the words of Warren Buffet marked to myth.
Another pricing mechanism was for one trader to sell a small number of a particular instrument to a chum in another institution or do a “swap” to set a price and then claim a realised profit.
Come the downturn, markets for financial instruments collapsed, the upshot being that some were marked down to zero, with thumping losses on the horizon. There was immediate demand from the banks and financial regulators for some financial instruments to be taken out of the trading portfolios, thus avoiding being marked down. This change was made within weeks and repeated previous mark to market debacles where profit is grabbed on the upswing, but loss relief is sought on the downturn.
In other words, heads we win, tails the taxpayer loses.
Lord Turner, currently chair of the Financial Services Authority, described some financial instruments as socially useless. We need accounting rules which will make them economically useless and so complex to value that smart bankers will no longer find them beneficial to invent. Could deprival value or more use of historical cost be the answer?
Unless and until the UK government accepts that our accounting regime is seriously flawed and neither accounting rule makers nor the UK accounting regulators can be trusted to ensure banks deliver reliable and prudent accounting numbers, which show a true and fair view of the economic substance of the banks, then bank accounting numbers will simply not be trusted and investors will understandably continue to be wary.
Stella Fearnley is Professor of Accounting at Bournemouth University. She has given written and oral evidence on the banking crisis to the Parliamentary Commission on Banking Standards and to the House of Lords Economic Affairs Committe