Should Regulators Be Able To Suspend Accounting Rules?

During the crisis, many people heatedly debated whether or not banks should have to mark their assets to reflect market prices. This requirement is called mark-to-market or fair value accounting. In July, the Financial Accounting Standards Board (FASB) appeared to be tightening mark-to-market rules even further, much to the dismay of banks. Apparently, that attitude has changed, sort of. Although FASB still wants investors to see fair value for assets, it isn't as concerned that regulators heed this standard. While I understand the motivation for giving regulators that flexibility, I worry it's misguided.

Let's think about a financial crisis like last year's, which was created by a credit crunch related to loan losses. Banks' assets and securities become highly illiquid as their values are plagued with uncertainty. So when some bank manages to sell something, the market value the asset sells for will be well below its book value. That value may even be less than what the asset is understood to be worth after the crisis ends. Yet, mark-to-market rules dictate that all banks are required to change the value of related assets on their books accordingly. Last year, this caused many banks to have serious problems, after their toxic assets lost a great deal of value.

On one hand, mark-to-market rules are problematic. If assets' values are only temporarily lowered due to extraordinary market conditions, then banks probably don't need to mark them down. And even worse is the possibility that marking assets to these temporary lower values can cause banks to incur huge losses or even fail.

On the other hand, mark-to-market rules make sense. If assets values decline permanently, then banks should be marking them down. Otherwise, the bank will look artificially healthy while its assets are really worth less than what's shown in its books.

The problem, however, is that it's generally pretty hard to tell whether or not these assets' values have changed temporarily or permanently. And even if the value changes are temporary, they may persist for long enough that they eventually affect the health of the institution. If it were easy to understand the magnitude and duration of these asset price changes, then suspending mark-to-market would be pretty uncontroversial. Of course, if that were the case, then there wouldn't be temporary declines in values to begin with, since there would be no price uncertainty.

From an investor standpoint, mark-to-market should be preferred. As long as all banks follow the same accounting rules, then investors can judge them all on equal footing. Even if their assets temporarily appear worse-off than they really are, investors can make a judgment themselves about whether those marks exaggerate reality.

But from a regulator standpoint, suspending mark-to-market would certainly make life easier. Regulators won't have to rescue a bank if they can leave the value of its capital artificially inflated by ignoring accounting rules. If a bank doesn't have to declare losses on its assets, it's like the banks hasn't really had any.

That's why Robert Hertz, chairman of FASB, said yesterday that he wants to provide regulators the ability to suspend mark-to-market accounting. The New York Times reports:

"Handcuffing regulators to GAAP or distorting GAAP to always fit the needs of regulators is inconsistent with the different purposes of financial reporting and prudential regulation," Mr. Herz said in the prepared text.

Maybe, but maybe not. If regulators are certain that a situation arises where the market is irrationally undervaluing assets, then they the ability to ignore that mispricing seems sensible. Yet, I'm entirely unconvinced that regulators necessarily know when that's the case.

I worry that if regulators are provided this flexibility, then they will always suspend mark-to-market accounting when a crisis hits. But in cases where the market permanently corrects the value of assets downward, their values would remain elevated in the regulators' eyes. Then, once the crisis appears to improve, banks will eventually cause a sort of secondary crisis when they are forced to begin realizing the decline in the value of those assets.

Moreover, I worry about how investors will react to this change. Imagine you're an investor. A crisis hits, and regulators step in to suspend mark-to-market accounting for a bank you own equity in. Are you worried? I sure would be -- regulators were so concerned about the bank's assets that they felt forced to suspend mark-to-market accounting! As an investor, I'll still do my own math to figure out what I think the bank's assets are worth. So investors might dump the stock anyway, endangering the value of the institution despite this move by regulators.

To me, providing regulators this flexibility sounds a lot more like assisting bailouts than quickly healing the financial system by resolving fatally wounded financial institutions. With this weapon in their arsenal, regulators will just work harder to prevent firms' collapse, rather than allow the inevitable to take place for institutions that deserve to fail.