Fair-Value Accounting Instills Exactly the Wrong Mindset in Bankers

Includes: KBE, XLF
by: Vernon Hill

On Thursday, the FASB is set to vote on changes to its fair-value accounting rule that would to give managers more latitude in using “significant judgment” in valuing financial assets, rather than forcing them to rely heavily on market prices.

Not a moment too soon. As we’ve discussed here regularly over the past several months, the “prices” banks must use under FAS 157 to determine the carrying values of their financial assets too often come from “markets” that are either a) highly illiquid, b) highly stressed in the current environment, or c) both. Thus FAS 157 marks tend to vastly understate the net present value of the cash flows the assets will ultimately generate. In forcing banks to take massive writedowns to reflect those bogus marks (and then raise new capital on ruinous terms), fair-value accounting has helped take a difficult global financial crisis and make it even worse.

But my main objection to FAS 157 isn’t just that, in practical terms, it’s proven to be unworkable. Worse, it reflects a speculator’s mentality that’s entirely out of place in an industry that ought to concern itself with prudent, long-term borrowing and lending. As I said last October:

In the financial markets, the traditional investment mentality has been replaced by a speculative one. While investors’ goal is to realize the value of their holdings over the long term, speculators believe everything can be instantly priced. Nothing has intrinsic value, and the object is the transaction itself.

Nothing reflects this speculative mindset more clearly than rulemakers’ insane obsession with market-to-market accounting, embodied by the FASB’s insistence that companies use market prices to value their financial assets, regardless of the asset’s type, maturity—and whether or not it even trades in a market active enough to even generate a meaningful price in the first place. The rationale behind the rule is that every loan and asset has an instant value, and that banks should run their businesses to maximize those instant values rather than build value for customers and shareholders over the long term.

In the real world, bankers who try to maximize instant value rather than build value for the long term usually come to a sorry end. Why should regulators encourage that kind of behavior? This ascent of the speculator’s mindset has already caused all kinds of mischief. I know of no one who doubts that, had FAS 157 been in place during the last banking crisis in the early 1990s, the entire banking industry would have been insolvent and, presumably nationalized en masse. How that would have been a better outcome than the steady recovery the industry finally went through, I have no idea.

The FASB will be right to alter FAS 157 so that common sense can once again play a role in the asset valuation process. The sooner bankers don’t have to think like speculators every working day, and can exercise some long-term judgment, instead, the sooner this banking crisis will be over for good.