Could Bank Rules End the Fair Value Debate?

It wouldn't be the first time bank regulators broke from accounting rulemakers to find a solution to dwindling capital reserves.

The fair value accounting controversy could be solved by changing banking regulations, rather than by making further alterations in accounting rules, say accounting experts who floated the idea past President Bush yesterday.

In a letter sent to Bush ahead of the G20 summit he is hosting beginning this weekend, Gerrit Zalm, chairman of the trustees of the International Accounting Standards Board, wrote that IASB and the Basel Committee have expressed a “willingness to explore” a solution to the procyclical problems banks currently face.

Zalm — who is the former deputy prime minister and finance minister of the Netherlands — noted that some observers believe fair value accounting accelerates the downturn of markets by requiring banks and other financial institutions to sell off assets to meet capital requirements, “thus depressing the market further.” Yet, argued Zalm, fair value accounting provides transparency and comparability of financial statements, “an objective that should not be sacrificed.”

Indeed, according to IASB Chairman David Tweedie, the “beauty of fair value accounting…is that it brought [the credit] crisis very very quickly into the open.” Testifying before the British House of Common’s Treasury Committee on Tuesday, Tweedie added that without fair value accounting, subprime lending might still be going on “and the disaster would be even worse.”

Tweedie and other witnesses called before the committee addressed the nexus between fair value accounting and banking regulations, and potential solutions for remedying the attack on fair value. By his lights, Tweedie said that bank regulatory and capital requirements are currently moving in lock step with accounting rules, but that shouldn’t be the case. He said that rulemakers can “break the link” and still provide more leeway for adjusting capital requirements while preserving the integrity of fair value accounting.

As an example, Tweedie elaborated on the talks held between IASB and the Basel Committee of banking supervisors, noting that bank regulators could require that some capital reserves be “undistributable” as a way of creating a permanent rainy day fund. He also said at least one banking supervisor suggested a similar tact, in which regulators would mandate that banks increase their capital requirements when the markets are “exuberant” and ease off the requirements — using a stated formula — in bad times, which is something Spain’s central bankers have done in the past.

Paul Boyle, chief executive of the Financial Reporting Council, told the Treasury Committee that there should be a separation between the way accounting rules and capital requirements operate, similar to the way corporate profits are calculated differently for tax and accounting purposes. “The purpose of accounting is to present an unbiased picture of the financial health of the organization. The purpose of prudential regulation is biased, and it is properly biased,” testified Boyle.

He asserted that banking regulation needs to be biased to protect depositors and insurance policyholders, whereas accounting needs to foster investor confidence and therefore requires unbiased treatment. “They have different objectives, and therefore they can use different numbers,” reasoned Boyle. In fact, bank regulators already use different methodologies to calculate regulatory capital. They start with the financial statements, then adjust them based on their regulatory objectives.

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