U.K. Lawmakers Defend Fair Value

A report from a House of Commons Treasury Committee says bad decisions at banks — not accounting rules — created the credit crunch.

The U.K. House of Commons has gone to bat for fair-value accounting — and the International Accounting Standards Board — saying it was “a bridge too far” to expect accounting rules to compensate for bad decision-making by banks.

The report by the House Treasury Committee, released last week, delved into the banking crisis as it relates to reforming corporate-governance policy and pay issues. Fair-value accounting was one of eight topics covered, along with credit-rating agencies, auditors, and the role of the media.

In a stinging critique of banks’ role in the global credit crisis, the report asserted: “The uncomfortable truth for banks is that market participants had over-inflated asset prices which have subsequently corrected dramatically. Fair value accounting has actually exposed this correction, and done so more quickly than an alternative method would have done…. We do not consider fair value accounting to be a suitable scapegoat for the hubris, poor risk controls and bad decisions of the banking sector.”

Bankers on both sides of the Atlantic have argued that fair-value accounting does not reflect the underlying economics and cash flows of investments that are held to maturity. In fact, the British Bankers Assn. and the American Bankers Assn. insist that the value of securities held to maturity should be carried at historical cost, and not written down on balance sheets and income statements as fair-value accounting prescribes.

According to the report, Paul Chisnall, representing the BBA, testified that historical cost accounting is a better way to value securities that are held over the long term. That’s because, he said, unlike fair value, “the historical cost model did not require a spot price, which was of little relevance unless the instrument was being sold.”

The BBA contends that fair-value accounting exacerbated the credit crisis, creating a “spiral of write-downs” and damaged banks’ capital ratios at a time when the markets had “effectively broken down.” Indeed, fair-value accounting forced companies, particularly financial institutions, to write down the value of billions of dollars of financial assets whose worth sunk as the markets for them dried up. In turn, the reported loss of value also drove down banks’ regulatory capital to the point where they didn’t have enough of a cushion to continue lending money.

But the Treasury Committee and representatives of the Chartered Financial Analyst Institute, the Association of British Insurers, and the Investment Management Assn. agreed that while fair-value accounting has a procyclical element that links it to banking capital requirements, it is not the culprit behind the credit crisis.

To be sure, the Treasury Committee noted that the link is not the fault of the accounting standards, but rather of financial statements being used “too crudely” in calculating regulatory capital requirements. The committee continued that the primary audience of financials is the shareholders, who want to see the true worth of their firm.

The committee also defended the International Accounting Standards Board’s decision last fall to forgo due process and rush out new fair-value rules that put European companies on the same footing as their American counterparts by reclassifying certain financial assets so that they are not subject to fair-value accounting. The IASB was under pressure from the European Union, as well as some heads of state — in particular Nicolas Sarkozy of France and Angela Merkel of Germany — to make a rule change under threat that the EU would pass its own rule that leveled the playing field.

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