The United States Federal Reserve is proposing new capital rules for banks. These rules, which are capital requirements put in place by the Federal Reserve to mitigate volatility, would set a standard for how much cash and capital a bank must keep on hand to offset its debts and loans.
Almost immediately, large U.S. banks and lenders like Citigroup and Wells Fargo have decried the proposal, saying that “the net effect of the change will force them to hold more capital over and above the stated requirements,” according to an article by Shahien Nasiripour in the Financial Times. Additionally, “because of different accounting treatments, their foreign peers will have their capital levels protected from changes in the market value of some securities holdings,” Nasiripour continues.
The accounting treatment that concerns U.S. banks involves those portfolios designated as “available for sale.” These holdings, according to U.S. accounting rules, are to be booked using mark-to-market accounting.
European banks, as Citigroup and others have noted, are not required to mark these portfolios at market value.
In a Competitive Enterprise Institute OpenMarket.org editorial, contributing editor John Berlau says that recent JPMorgan Chase losses may be magnified by mark-to-market accounting.
JPMorgan Chase recently reported a $2 billion loss from a “failed hedging strategy,” a hedge created by a synthetic credit portfolio operated by the firm’s Chief Investment Office. But, notes Berlau, the losses were reported by the Wall Street Journal and others as “significant mark-to-market losses,” wherein the value of the firm’s assets has dropped due to its current market value in addition to any poor hedging decisions made by fund operators at JPMorgan Chase.
“It seems that the primary reason for J.P. Morgan’s loss is that hedge funds bet against its position in certain securities,” says Berlau. “Mark-to-market losses like this are frequently paper losses that translate into much smaller actual losses, or sometimes even no losses at all,” he continued.
Additionally, such mark-to-market activities “can do significant damage when [they are] enmeshed in mandates such as regulatory capital rules,” Berlau says.
New York Times financial writer Floyd Norris, in a recent article, explores the United States debt crisis and subsequent rebound happening now. Both borrowers, faced with foreclosures and bankruptcy, and lenders, facing massive losses due to credit defaults, have been slow to recover.
But the situation has turned, says Norris, noting that in the first quarter of 2011, required debt service payments now account for only 10.9 percent of disposable income – the lowest since 1994.
However for the debt rebound to continue, the deleveraging process must be a key component, Norris says. The McKinsey Global Institute, in an analysis published in early 2012, called this phase “the good part.”
“Growth rebounds and government debt is reduced gradually over several years,” says the analysis. But for deleveraging to begin, says Norris, “it is important for lenders to face reality, admit losses and deal with them.” Though banks were tempted to obscure losses, mark-to-market accounting rules limited the extent to which this could be done.
Mark-to-market, weakened by bank lobbying, still had some positive effect on accepting losses as opposed to attempting to obscure them in hopes of a quick recovery, says Norris.
In a contribution to Resource Investor, Vin Maru writes that the western financial system’s reliance on pure fiat currency “is the virus that will be the death of the financial world as we know it.” Regarding the economic downturn of 2008 and subsequent Troubled Asset Relief Program (TARP), Maru criticizes the actions of the government, saying that the financial system “will not be allowed to naturally correct and adjust” because of the TARP bailout.
“Banks which own toxic assets are no longer keeping financial records under generally accepted accounting principles (GAAP) or applying mark to market valuation for the assets they hold on their books,” says Maru.
The banks are not to blame, though, he says. The bailout and lack of GAAP and mark-to-market regulation, says Maru, simply act as “bandages to conceal the wounds from the public’s eye.” Capital injections and “printing money,” says Maru, “seems to be the cure to all sovereign debt problems” both domestically and globally.
Investment bank giants Goldman Sachs and Morgan Stanley have entered discussion on whether or not to scale back each company’s use of mark-to-market accounting.
Shifting certain reporting measures away from mark-to-market would mean that Goldman Sachs and Morgan Stanley would use historical cost accounting, valuing assets at their original purchase price rather than current market value.
The Wall Street Journal report on the potential shift said that only a small portion of the companies’ $1.7 trillion in combined assets would be affected.
Such a move is not guaranteed. As The Wall Street Journal reported, “there are wide differences of opinion among executives” of both companies. Should Goldman Sachs and Morgan Stanley decide to make the switch, no regulatory approval would be required, allowing for a swift transition if the companies’ leaderships so chose.
A 2008 change to classification as bank holding companies allows for less strict regulation in situations like these. It also allowed both companies to tap into the Federal Reserve’s emergency fund discount window during the financial crisis.
The National Association of Pension Funds (NAPF) recently warned companies that mark-to-market accounting for pension plans is “inappropriate.” Mark-to- market, says the NAPF, introduces unnecessary short-term volatility.
The counter to this volatility is extreme caution in investment policy and a reliance on low-return government bonds, both methods drive up pension plan costs, says the NAPF’s report.
“The current standards are not appropriate for the long-term nature of pensions. They allow short-term stock market volatility to perversely affect pensions and their long-term strategy by presenting large deficits which may prove inaccurate in the long run,” says NAPF chairman Lindsay Tomlinson.
United Kingdom-based NAPF follows the direction of the International Accounting Standards Board (IASB) while the United States follows the Financial Accounting Standards Board (FASB).
The two governing bodies have attempted to merge standards recently, with mark-to-market accounting being the main hot-button issue. Some notable United States companies, including Verizon, Honeywell, and AT&T, have made the switch to mark-to-market valuation of their pension plans, partially as a prediction that the FASB will adopt the IASB’s mark-to-market standards.
In a recently released study by Interactive Data Corporation, mutual fund industry professionals continue to invoke fair value procedures at an increasing rate.
The survey, which covered 134 Chief Financial Officers, Chief Compliance Officers, and valuation team members, showed an increasing attention to market volatility as it relates to fair value accounting procedures.
“The heightened level of volatility in the market draws attention to the importance of fair value practices for mutual funds investing in international equities,” said Rob Haddad, director of Evaluated Services for Interactive Data. Haddad continued, “Our survey found that mutual funds are generally well-prepared for volatile market scenarios, with predefined fair value procedures in place to handle such events, and formal back-testing processes to examine how these procedures worked in practice.”
Among mutual funds, 36% reported that fair value is being applied every day, up from only 10% in 2004. The other 64% of funds reported using “triggers” — a process that pays attention to market movements and benchmarks — to apply fair value procedures for the fund. The strategy for triggers varied greatly in method, scope, and complexity, said the study.
In a Bloomberg editorial, University of Chicago Booth School of Business professor Haresh Sapra says that conventional thinking on financial regulation may not be entirely beneficial. “The view that greater transparency enhances market discipline and therefore economic efficiency holds true only in a ‘Robinson Crusoe’ economy, that is to say one in which a single decision maker is learning about a company whose decisions are taken as given and whose future cash flows or economic fundamentals are therefore fixed,” says Sapra.
Fair value accounting is one method that regulators have undertaken to improve transparency, requiring that assets be accounted for at market price (rather than purchase price) to give a more accurate view of a holding’s value to both insiders and outsiders of a company. But financial insiders point to increased volatility in financial statements, leading to unnecessary and unintended instability.
The more that a financial institution relies on short-term pricing and value changes, the more at-risk it is for a “feedback loop,” as “decisions of financial institutions are more likely to be based on second-guessing of their competitors than on perceived fundamentals,” says Sapra. “Put differently, in trying to enhance market discipline, reliance on market prices via fair-value accounting weakens market discipline,” he concludes.
Amen to that, Professor! Let’s do both–print holdings at purchase price and then footnote the exact mark-to-market effect. This attains both goals–it gives long-term decision-making room to think and operate and fully discloses the market value effects on the institution. Why isn’t this a perfect solution? It provides more disclosure and less volatility–win-win!
The Basel III regulations, formed by the Basel Committee on Banking Supervision to overlook banks from an international perspective, are dangerously overlooked by many in the financial industry, says Ben Wright of Financial News. In response to the recession and credit crisis centered around 2008, new regulations from Basel III required that banks (and counterparties) adjust for potential losses against market prices as the risk of failure for a bank, company, or government increases.
This had astounding effects, says Wright. “The Basel Committee on Banking Supervision has calculated that two-thirds of the losses made on derivatives during the credit crisis came not from the default of counterparties but from the deterioration in their credit quality,” he says. Standard & Poor’s believes that of all the Basel committee’s actions, this requirement has “the greatest potential implications for the behavior of financial institutions in the medium term.”
These new rules were necessary because prior regulations ignored potential mark-to-market losses, says Wright. It was the timing and complexity of FAS 157 – the 2007 mark-to-market requirement – that ultimately caused undue stress for financial institutions in the United States.
“Often the regulatory response to one crisis sets the parameters for the next, says Wright. “All those governments poised to push through new financial regulations in the coming months should examine the example of new counterparty credit risk rules…and ask themselves whether now is the best time to field-test their unproven ideas,” Wright concludes.
Mark-to-market accounting is speeding the collapse of defined benefit pension plans according to a Leeds University study, reports Ellen Kelleher of the Financial Times. The issue of plan deficits arises after many defined benefit plans have invested in long-dated bonds instead of traditional equities, attempting to match the plan’s assets to its liabilities.
Mark-to-market accounting “has led to greater volatility in comprehensive income and the recognition of substantial and often volatile pension deficits in the statement of financial position,” said the study’s authors, Iain Clacher and Professor Peter Moizer. Mark-to-market has caused the decline in defined benefit plans “as corporate managers have increased the pace at which these schemes are closed to new members and to future accrual by existing members,” the authors continued.
In the United States, however, many pension plan administrators for large companies like Verizon and Honeywell have made the switch to mark-to-market for their pension plans. Analysts believe US companies have made the shift partially as a proactive move in the event that U.S. Generally Accepted Accounting Principles (GAAP) would begin to require mark-to-market in the near future. Many also point to the practice as a strategic move, allowing recession-hit pension plans to recognize losses in one year as opposed to smoothing losses over many years.
The ideal model, according to the study, would include the present value of future cash flows and cash payments by benefit plan administrators.