Is the Fed on Investors' Side?

by: Belvedere

If the remarks of Fed Governor Elizabeth A. Duke are any indication, the answer is a flat "No."

At the outset of her remarks at Monday's AICPA banks and savings institutions conference, she gave the traditional disclaimer that her comments reflected her views and do not necessarily reflect those of the Board of Governors or staff. Let's hope they don't.

By the time you get to just the seventh and eighth sentences of her speech, the hair on your neck should be standing at attention:

Further, the accounting and regulatory changes made now will help shape future business models for financial institutions and thus influence credit availability. It is important to ensure that these changes facilitate, not hinder, the decision-making processes that support financial intermediation and economic activity.

Maybe regulatory changes made now will help shape future business models - you know, like keeping adequate capital on hand - but the accounting changes will shape future business models? Sounds like an ominous reference to the IASB's exposure draft on financial instrument classification and measurement, with its contorted classification scheme for putting financial instruments onto amortized cost accounting, instead of fair value reporting. (Posted about this on Monday - link here.) We find out for sure, later, that she's a fan of the IASB approach.

Accounting changes aren't supposed to shape business models - accounting is supposed to present economic information in a neutral, objective fashion so that investors can make informed decisions about where to place capital. If business models respond to changes in accounting standards, it's not usually a response designed to improve information provided to investors. Apparently, Governor Duke doesn't quite buy into the argument that accounting is supposed to give investors neutral, objective information. She believes that accounting has other duties:

... I feel it is crucial that an accounting regime directly link reported financial condition and performance with the business model and economic purpose of the firm. It is difficult for me to comprehend the value of an accounting regime that doesn't make that link.

I am sure that Governor Duke can comprehend the value of an accounting system that is de-linked from reported financial condition and performance with the business model and economic purpose of the firm. I'm wondering if she really means she just won't tolearate an accounting system that's objective and neutral for investor reporting - because that's what's at stake.

She expresses more support for the amortized cost approach:

In this regard, the business model and risk-management approach taken by the reporting entity--as well as the way in which the value of the instrument itself is likely to be realized--should be factored into the measurement determination.

If the business model is predicated on the trading of financial instruments for the realization of value, or other strategies that essentially focus on short-term price movements, then fair value has relevance...In contrast, if the business model is predicated on the realization of value through the return of principal and yield over the life of the financial instrument, then fair value is less relevant.

Governor Duke is supporting "intent-based" accounting - whereby if a bank's managers intend to hold a security or a loan over the full term, then what it's actually worth doesn't matter. In her own words, "the fair value is less relevant" - which might be so for a regulator, or for a financial institution's management, but definitely not for an investor. How else can investors assess whether or not management is dragging its feet on recognizing impaired assets? They can't - not with straight amortized cost accounting, which demands an impairment model requiring a high-voltage cattle prod to get managers to recognize writedowns. (Or at least, it used to, before the FASB gave managers a lot more leeway to report a lot less writedown. See Volume 18, No. 9, "Don't Worry, Be Happy: Effects Of New Fair Value FSPs.")

She also states that the "the reliability of amortized cost is not as questionable," compared to estimated fair values, which totally ignores the issue of relevance of what's being measured. She'd rather be exactly wrong with amortized cost amounts than vaguely right with fair value amounts on a bank balance sheet, I suppose.

Bottom line, this is the same kind of thinking that the bankers have been peddling the last couple of years - and continue to do so. You can see it in this letter from the American Bankers Association to Treasury Secretary Geithner - where they're imploring him to use next week's G-20 summit to break the back of the FASB's momentum towards a project that would increase financial instrument reporting at fair value.

Another topsy-turvy point made by the banking supporters - and Governor Duke, too: fair value reporting will harm community banks because of the added cost of reporting. That sounds a lot like the SOX 404 arguments, and a lot like the venture capitalists crying that tech firms will dry up if they have to expense stock compensation.

This one is just as disingenuous. The argument is in favor of keeping investors in the dark, for the sake of community banks. The interesting thing: according to Kansas City Federal Reserve Bank President Thomas Hoenig, "the top 20 banks own 70% of the [banking system's] assets." Wouldn't it be great if fair value accounting standards shone more light on their activities, instead of being shielded by an excuse for the little banks?

September has been widely expected to be a turbulent month for investors - if you're looking at just the markets. So far, it's been pretty kind. But investors might be taking it on the chin in other ways this month, if you look at what's transpiring in the way information gets reported to them. Next week's G-20 meeting could prove very unsettling for investors.