4/09/2008: IMF comments on fair value accounting

Excerpts from the International Monetary Fund's paper The Recent Financial Turmoil—Initial Assessment, Policy Lessons, and Implications for Fund Surveillance


Valuation, disclosure, and accounting. Weaknesses in the application of accounting standards and gaps associated with the valuation and financial reporting of structured products contributed to the current crisis. Further guidance is needed on how to apply fair value accounting through the cycle, particularly when markets are illiquid. Supervisors need to ensure financial institutions develop robust pricing, risk management, and stress testing models, and collaborate with international standard setters to achieve better cross-border convergence of accounting and disclosure practices. Additional effort is needed to provide markets with accurate and timely reporting of exposures to structured credit products and other illiquid assets, as well as the valuation and accounting methodology used.
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The inter-relationship between regulation, accounting practices, and ratings may have exacerbated the market turbulence. Basel capital requirements encouraged securitization and off-balance-sheet funding, while fair value accounting, in combination with relatively illiquid markets for most structured credit products, contributed to procyclical selling pressures and significant price gapping once markets came under stress.
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The accounting treatment of structured products may have resulted in procyclical valuations. Structured products are often classified in categories that are subject to fair value accounting. During the upturn, the booming demand for structured products boosted valuations and banks’ profits and equity. Conversely, during the downturn, valuations became depressed as demand and liquidity evaporated. It is thus arguable that fair value accounting did not provide accurate information about the banks’ true risk profile through the cycle. The frequent incremental revisions in bank losses after the onset of the turmoil further reduced market confidence.
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The procyclicality of fair value accounting was amplified by the use of portfolio covenants or triggers. These triggers often required sales, margin calls, or additional collateral requirements as valuations declined, which induced a vicious cycle forcing sales that otherwise would not have been made. As assets lost value and were sold, the liquidity of financial institutions was impaired.
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The challenge is to find better ways to apply fair value accounting through the cycle so as to mitigate procyclicality. Changing accounting standards at the height of the crisis would risk adversely impacting investor confidence. However, going forward, there is a need to provide more guidance on the calculation and application of fair value accounting rules, in particular for assets that are not actively traded. Specific disclosure of the origin of “write-ups” as well as “write-downs” should become the norm.