The Value of Fair Accounting

I was a reluctant convert to fair value accounting, because I like standardization in accounting that allows for comparisons across corporations.  Also, unlike the complaints that emanate from financial companies that argue that fair value is procyclical, my experience has been that financial companies mismark their assets high, no matter what.

But when I read this article in the New York Times, it hit me.  The reason that the banks complain about fair value accounting being procyclical, is that they are mismatching assets and liabilities.

Think about it.  The argument that the banks make is that they are solvent.  Unfavorable temporary asset price changes should not be reflected in the accounting.  But if liabilities are marked to market at the same time, the difference should be minimal if the cash flows of the assets and liabilities are matched, unless there is a credit problem with the assets.

The thing is, with most banks, they have a large amount of their financing through deposits, savings accounts, CDs, and repo funding, all of which is short-dated, relative to the length of their assets.  (For floaters, look at the maturity, not the reset period.)

Thus, it should be no surprise when a bank is mismatched short versus its assets that it would squawk during times of crisis, and complain about fair value accounting.  But the problem isn’t the fair value accounting; it is the cash flow mismatch.  Banks try to make extra money off of that mismatch in good times, only for it to become a deadly risk in times of bad credit and liquidity.

Let the banks do what the insurers do, and come close to matching assets and liabilities.  If they do that, the financial system will become a lot more stable, and financial crises will be much less common.

And at that point, it won’t matter what accounting system is used, so long as those using book value impair assets fairly.  Still, I would prefer fair value.  Investors deserve the best information, even if it complicates life for corporate managements.

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