4/9/2008: Interim Report of the IIF Committee on Market Best Practices comments on fair value accounting

Excerpt from Interim Report of the IIF Committee on Market Best Practices
Institute of International Finance

B. Widely Encountered Problems

73. Over the past decade, fair-value/mark-to-market accounting has generally proven highly valuable in promoting transparency and market discipline, and continues to be an effective and reliable accounting method for securities in liquid markets. When there is no or severely limited liquidity in secondary markets, however, it has the potential to create serious and self-reinforcing challenges that both make valuation more difficult and increase the uncertainties around those valuations. In addition, there is a wide perception that mark-to-market accounting in circumstances of widespread illiquidity deviates from underlying fundamental values. There are questions about whether fair-value accounting approaches have increased the severity of the market stress relative to other possible alternatives and, if so, whether this reflects a fundamental feature of such approaches or weaknesses in the current state of their implementation. In light of the magnitudes of the writedowns and their systemic impact, it is essential that these broadly encountered questions be addressed.

74. A critical subset of issues revolves around whether mark-to-market exacerbates the overall degree of risk aversion in the marketplace and thereby contributes in a procyclical manner to the continuation and possible worsening of market stress. The effect of these issues in the context of a fair-value accounting regime that covers a much wider scope of instruments than ever before has created the potential for confusion and even for possible misreading by investors. In circumstances where doubts about products and underlying credit quality undermine valuations inducing extensive margin calls, there is the danger of a precipitous and destructive downward spiral, which reinforces the procyclical impact.

75. For these reasons, the Committee believes that broad thinking is needed on how to address such consequences, whether through means to switch to modified valuation techniques in thin markets, or ways to implement some form of “circuit breaker” in the process that could cut short damaging feedback effects while remaining consistent with the basics of fair-value accounting. And, while there is no desire to move away from the fundamentals of fair-value accounting, the Committee feels that it is nonetheless essential to consider promptly whether there are viable sound proposals that could limit the destabilizing downward spiral of forced liquidations, writedowns and higher risk and liquidity premia. The Committee is developing specific proposals for consideration in a timely fashion.

76. The Committee recognizes that these are not new issues, but believes that the interactions observed between market liquidity and announced or anticipated writedowns are concerning and provide evidence of potentially destabilizing feedback effects. The Committee’s discussions on this topic have also noted the arguments that forbearance in assessing the scale of losses may prolong a crisis and worsen its ultimate impact. Moreover, the Committee stresses that any “circuit breaker” would be intended to address situations where the market fails substantially to provide inputs for valuations reasonably in line with underlying values; such a “circuit breaker” would not affect recognition of actual losses. Use of any “circuit breaker” would have to be subject to clear disclosures and would include provisions to prevent arbitrage or other abuse.