A Fair Value Shake-Up?

Leo Kolivakis's picture

Submitted by Leo Kolivakis, publisher of Pension Pulse.

Glenn Gottselig of the IMF Survey Magazine reports that experts warn that financial system risk are still high:

Opening the November 5-6 research conference, IMF Managing Director Dominique Strauss-Kahn remarked
on the positive effects of the timely and effective policy
interventions at the global level that have helped stave off an even
worse outcome to the recent global crisis.


noted that macro-financial linkages are at the heart of the two-way
interactions between the real economy and the financial system. “One of
the most important lessons we painfully learned is that we need to have
a much better understanding of macro-financial linkages,” he said. “At
the IMF, we will utilize the results of recent research on
macro-financial linkages in order to help our membership devise
policies that promote global financial stability and economic growth.”


The Economic Forum, chaired by IMF Chief Economist Olivier Blanchard, wrapped up the 10th
Jacques Polak Annual Research Conference in Washington, D.C. Since it
was first launched, the research conference has become one of the major
international forums for researchers and policymakers to exchange their
views about issues related to the global economy.


Graceful exit


the world, discussions are under way on how to best move toward
unwinding public sector support. Of all the measures of public support
implemented thus far—fiscal and monetary policy, interventions to
specific institutions, and government support programs—perhaps the one
most delicate to unwind will be monetary policy.


Federal Reserve governor, Laurence Meyer, explained that exit for the
United States will mean raising the federal funds rate; withdrawing the
reserves that were put in by the various programs; and shrinking the
balance sheet by selling previously purchased assets—such as,
mortgage-backed securities—or letting short-term assets “run off” as
the various facilities or programs are scaled back or shut down.


predicts the federal funds rate will not be increased until the middle
of 2011, saying the Federal Reserve would, however, tighten earlier if
another asset bubble developed. Despite having just emerged from a
collapse in the housing market, Meyer believes, “we are already on
bubble alert.” He points to market concerns of an emerging bubble in
the corporate bond and other markets, noting credit spreads have
disappeared, equity prices are increasing, and housing market prices
are slowly rising.


Market concern over long-term inflation
expectations might also lead to a tightening, as might a collapse in
the dollar. “If there was freefall in the dollar, even if the
short-term economic conditions weren’t very good, the Fed would have no
choice but to raise rates,” he said.


Policy overhaul


it comes to redesigning monetary policy, there is disagreement as to
how this might best be accomplished. Wharton finance and economics
professor Franklin Allen believes more checks and balances could be
built into the Federal Reserve System. “We need to have a third
mandate—a financial stability mandate,” he said.


But more
importantly, he says, outsiders should be checking the Federal Reserve.
Allen favors a financial stability board, which would be independent
from the Fed, with members sitting on the Federal Open Market
Committee, not with a majority, but perhaps a substantial minority, so
that given a dissent in the Board, they would be able to provide a
counter effect.


Allen sees
quantitative easing as an extremely risky policy, and as something that
has been undertaken with very little discussion in policy or academic
circles: “The notion is that you print money and buy up long-term
bonds, but what happens if inflation ticks up?” Selling the bonds and
reversing the liquidity could be problematic and, he argues, central
banks need a mechanism to check what is going on and prevent such risky


On the other hand, both Meyer and former Federal
Reserve governor, Randall Kroszner, believed this might compromise the
widely cherished independence of central banks. “If you ask a central
bank whether it should intervene directly in an asset bubble, they
would say, ‘yes’, but we have additional tools to do that,” said Meyer
“we don’t want to compromise monetary policy being supervised in
regulatory policies.” Panel chair Blanchard summed up the essence of
the discussion, asking, “How can you balance this central bank
independence and avoid misbehavior? If you think of monetary policy as
a set of tools, then it seems wrong to have two decision makers. The
need for coordination and information means there can only be one
institution using these tools optimally.”


Too broad a mandate
could also risk overloading central banks, particularly in emerging
markets, a view held by Brookings Senior Fellow and Cornell professor,
Eswar Prasad. Where a central bank has a well-defined mandate, he
believes it could be possible to incorporate many of these issues
within that mandate. “Although the world has changed in many ways,” he
said, “we should not be throwing out everything that we thought we


What to watch for


Picking up and
building on one of the potential risks referred to earlier by Meyer,
Allen noted that while a run on the U.S. dollar might be less likely,
there are other advanced economies where the risks are greater,
particularly those that followed policies of quantitative easing and
purchased large amounts of financial assets. “If there is a run on the
currency, it is going to be very difficult for [the central bank] to
sell these assets back into the market without substantially raising


Global imbalances are again
beginning to raise concerns. Pressures remain in many economies around
the world, says Prasad, where many economies, such as China, Japan and
Germany, ride the coat-tails of the United States. In China, Prasad
noted that just in the first six months of 2009 China’s state banks had
pumped $1 trillion of lending into mostly state-owned enterprises. But
the huge stimulus could result in a problem of overproduction that
would again lead to imbalances with the need to export surplus output.
Both Prasad and Allen worry that the crisis may have also incentivized
emerging markets to continue with a policy of amassing huge stocks of


Allen points to countries such as Korea and some
others across Asia that may have come through the crisis in good shape
and avoided the large decrease in GDP and increases in unemployment
experienced by other export-oriented countries. He suggests these
countries will conclude, rightly, that they need more reserves. Prasad
says a number of countries thought to have had vast reserves saw them
depleted very quickly during the height of the crisis. Here, they both
agree that changes to the international architecture—through better
Asian representation at the IMF—would be helpful, but these changes
need to move more quickly than they are at present.


markets are moving out of the crisis with a new perspective, argues
Prasad, where they now recognize better the importance of strengthening
financial systems, but doing so in very limited contexts. Prasad sees a
new path developing as emerging markets move forward with their
financial development and broadening financial access, one that
emphasizes the importance of regulation.


“Perhaps ultimately
what we should hope for is a convergence of the emerging markets moving
toward more sophisticated, but better regulated, financial systems and
perhaps the United States move toward a less sophisticated, in some
ways, but more stable financial system.” But with no agreement yet
among experts on what are the optimal regulatory structures for less
developed financial markets, he sees a need for a great deal of work to
be done in the area.

The IMF, the OECD and the
World Bank need to study macro-financial linkages more closely. In
particular, they need to understand the symbiotic relationships between
pension funds, insurance funds, sovereign funds, investment banks,
hedge funds and private equity. Once this is examined, they can better
understand how the shadow banking system influences monetary policy and
the credit cycle.

International institutions also need to
understand the correlations between various public and private asset
classes. With all this liquidity chasing yields all around the world,
asset classes are a lot more correlated now more than ever. The world
is one big correlation trade and as long as it keeps humming along,
everything will go smoothly. But if there is a hiccup, watch out, it
will reverberate around the world.

Speaking of hiccups, Rachel Sanderson and Nikki Tait of the FT report that Brussels is warning on fair value shake-up:

has warned that a radical overhaul of rules on how banks value their
assets could lead to greater volatility in their accounts, undermining
broader financial stability.


Commission officials have sent a letter to the International Accounting
Standards Board criticising the rule-setting body’s proposals for
financial institutions, the first stage of which is scheduled to be
published this week.


The IASB’s standards are used or are being
adopted by more than 110 countries, including India, Japan, South
Korea, Canada and those of the European Union. The IASB rule proposals
could provide a blueprint for its US counterpart which is considering
amending its own rules. IASB and US officials are aiming for
convergence of their standards by June 2011.


IASB overhaul is aimed at addressing criticism of so-called “fair
value” accounting, the system of valuing assets at market prices which
some banks and policy makers believe exacerbated the credit crisis by
increasing volatility in banks’ accounts. When markets fell sharply,
banks were forced to mark down the value of their assets, leading to
heavy losses.


The IASB reforms will allow more flexibility in
determining which bank assets must be marked to market and which can be
valued according to so-called amortised cost accounting, which smooths
out market volatility. But Commission officials believe the overhaul
does not go far enough to limit the use of fair value accounting.
Analysts say some European banks with large investment banking
activities would be hit disproportionately.


the letter to the IASB, Jörgen Holmquist, director general of Internal
Markets at the European Commission, said more assets might be marked to
market under the new system than even under existing rules. He urged
the IASB “urgently” to consider further changes.


“It would seem
that the current draft may not yet have struck the right balance
between ‘fair value’ accounting and ‘amortised cost’ accounting,” he
says. The letter, dated November 4, comes as a Brussels committee is
expected to meet on Wednesday to discuss its response to the overhaul.
The near final draft already includes a number of changes demanded by
Brussels in September.


Those changes include applying fair value more flexibly than in earlier proposals.

the IASB proposed that if an asset earned predictable cash flow such as
a loan, then it could be valued by amortised cost accounting. If it
delivered an unpredictable return such as a share portfolio or
derivative, then it had to be marked to market.


the new proposals, accounting experts say the IASB has given banks and
insurers more flexibility on some specific financial instruments.


IASB also unexpectedly decided to delay a rethink of how banks account
for liabilities until next year, allowing financial institutions to
continue the disputed practice of marking debt to market. This allowed
banks to book gains when the value of their debt traded in the market
fell sharply on concerns over their financial health.

not only banks and insurers that will be looking at the new accounting
rules. Pension funds will also be scrutinizing them, trying to gauge
the impact on their private market assets and other less liquid assets.

Reuters reports that the total pension deficit of UK corporate pension
funds fell by more than a third in October, despite a dip in stock
markets, mainly due to changes in the method of assessing pension liabilities:

Pension Protection Fund (PPF), the agency set up in 2005 to pay
compensation to the members of underfunded pension funds when their
sponsors goes bust, said on Tuesday the aggregate deficit fell to 97.6
billion pounds from 148.9 billion pounds in September. The deficit was
77.6 billion pounds in October last year.


the month, pension assets decreased due to a fall in both UK and global
equity markets. The FTSE All Share Index fell by 1.9 per cent in
October. Pension liabilities also rose on the back of lower gilt
yields, the PPF said.


PPF said the new actuarial assumptions reflected "more accurate"
figures provided by schemes and reduced liabilities by about 7 percent
in October.


the actuarial change not occurred, aggregate funding deficit would have
worsened over October to 168.8 billion pounds, it added.


The number of schemes in deficit in October fell to 5,867 from 6,174 in September.

Last week the PPF said its deficit more than doubled to 1.2 billion pounds in the 12 months to end-March.

voila! Change the rules and shave off billions in toxic assets and
pension deficits! Don't you love accounting rules and actuarial
assumptions? Who said capitalism is rigged?

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Rainman's picture

IASB and FASB plan to converge standards by June 2011 ??

Shucks, this baby will blow long before then. And it won't be just a " hiccup ".

This all looks like the Great Titanic Deck Chair Rearrangement .

Anonymous's picture

Strangely let us recap
USD carry vs Yen 2005 2007
accounting creativity
Equities markets unfazed by declining revenues and profits down 19 yy. markets up 120 in russia,53 % in W europe

The rebirth of the SIV called ...

Concealing of truth in the financial statements
BRUSSELS (Reuters) - Twenty-two large banks in Europe may have accumulated credit losses of close to 400 billion euros ($587 billion) for this year and next, the International Herald Tribune reported on Saturday.

That is fine as long as there is no despair

Anonymous's picture

This is the most significant part of the article:
"The IASB also unexpectedly decided to delay a rethink of how banks account for liabilities until next year, allowing financial institutions to continue the disputed practice of marking debt to market. This allowed banks to book gains when the value of their debt traded in the market fell sharply on concerns over their financial health"

This means that (for example) a failing business whose debt is trading at (say) 60% of par, can TAKE AS PROFIT the 40% uncovered by the market price. That's right, rduce their liability by 40% and crdit it to profit! IN SPITE of the fact that the busines still has a complete liability to repay 100% of the debt. So the IASB (and you can be sure the FASB too) are alllowing OVER valuation of assets and UNDER valuation of liabilities.

Leo Kolivakis's picture

Very interesting, thank you. Does anyone else have comments on how  banks account for liabilities and what this means for future financial risks?

Margin Call's picture

Hey Leo, not sure if you caught this story in La Presse this morning, but would definitely be of interest to you:


Just what we need, a mindless return to taking pension funds to task because they don't take enough risk! It's so sad, you'd think the past few years haven't happened. I salute central bankers of the world for their successful serving of a nice moral hazard/amnesia cocktail. Man, this one is strong and will probably leave a killer hangover, as usual.

Leo Kolivakis's picture

Thanks for the heads up, will wait for CPPIB's results before I comment on it.

Winisk's picture

Kinda like playing Snakes and Ladders with my daughter.  I land on a Snake, I go down.  She lands on a Snake, she changes the rules and says the big snakes don't count.

Anonymous's picture

Excellent article. It reminds people about all the issues still out there. Solving the deflated bubble problem with creating yet another set of bigger bubbles is clearly not the answer.

admin: http://invetrics.com

Anonymous's picture

Amortised cost for toxic assets surely just means spreading your loss over 25 years rather than taking an upfront hit and gives no incentive to dump the bad assets at a realistic price. Way to create a zombie banking system. Japan will have nothing on this.

Daedal's picture

When the hell are we going to converge GAAP into IFRS? You'd not only have mark to market, you also get the benefit of writing UP prior right downs. No LIFO under IFRS though...

Chignos's picture

Mark-to-myth just ensures that ever-smaller black swans can pose systemic risk.

Anonymous's picture

Or even bigger black swans can pass as 'more good news'!

Anonymous's picture

Unemployment seems to be the last thing any of these folks want to look at! It is the first thing that needs to be taken care of.

No tax revenue= bankrupt state pensions. The bankrupt pensions (and they will all go bankrupt) are going to be nationalized to fund SSI. Retirement for JS6 is gonna consist of SSI and rationed health care!

11% unemployment will take the TBTF's down by the numbers. At 13% every last thing on the Fed balance sheet will be worthless. No bank in their right mind especially the TBTF's would do a reverse repo. Every last MBS, CDO, CMBS,CDS and all the other 20,000 securities the Fed now owns will soon be worthless. Good luck pulling liquidity with that garbage. Besides there is nothing to pull anyway it's all been used to pay defaulting debt and pump the market.

This great ponzi is completely dependent on the usury that rides the back of JS6's unemployed ass!!

The folks that have the power to do something about it at least here in the U.S.!! Have dawned rose colored glasses and wandered off on the euphoric power trip of nationalized health care. They can't see and don't care about the flock of Black Swans that unemployment really is!!

Anonymous's picture

Would you believe 22% using Clinton definitions?