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PA R T I I I
Financial Institutions
Mark-to-Market Accounting and Financial Stability
FYI
The controversy over mark-to-market account-
ing has made accounting a hot topic. Mark-
to-market accounting was made standard
practice in the accounting industry in the
United States in 1993. U.S. Generally Accepted
Accounting Principles (GAAP) established a
number of ways for measuring fair value,
depending on whether a financial instrument
is traded on an active market or in the
absence of an active market. Canadian GAAP
are similar to U.S. GAAP, as well as to stan-
dards in effect in those countries (approxi-
mately 110) that have adopted a set of global
standards, known as International Financial
Reporting Standards (IFRS), developed by
the
International
Accounting
Standards
Board (IASB).
The rationale behind mark-to-market
accounting is that market prices provide a
better basis for estimating the true value of
assets, and hence capital, in the firm. Before
mark-to-market accounting, firms relied on
the traditional historical-cost (book value)
basis in which the value of an asset is set at
its initial purchase price. The problem with
historical-cost accounting is that changes in
the value of assets and liabilities because of
changes in interest rates or default are not
reflected in the calculation of the firm s
equity capital. Yet changes in the market
value of assets and liabilities
and hence
changes in the market value of equity capi-
tal
are what indicates if a firm is in good
shape, or alternatively, if it is getting into
trouble and may therefore be more suscepti-
ble to moral hazard.
Mark-to-market accounting, however, is
subject to a major flaw. At times markets stop
working, as occurred during the subprime
financial crisis. The price of an asset sold at
a time of financial distress does not reflect its
fundamental value. That is, the fire-sale liqui-
dation value of an asset can at times be well
below the present value of its expected
future cash flows. Many people, particularly
bankers, criticized mark-to-market account-
ing during the subprime financial crisis,
claiming that it was an important factor dri-
ving the crisis. They claim that the seizing up
of the markets led to market prices being
well below fundamental values. Since mark-
to-market accounting requires that the finan-
cial firms assets be marked down in value,
this markdown creates a shortfall in capital
that leads to a cutback in lending, which
causes a further deterioration in asset prices,
which in turn causes a further cutback in
lending. The resulting adverse feedback loop
can then make a financial crisis even worse.
Although the criticisms of mark-to-market
accounting have some validity, some of the
criticism by bankers is self-serving. The criti-
cism was made only when asset values were
falling, when mark-to-market accounting
was painting a bleaker picture of banks bal-
ance sheets, as opposed to when asset prices
were booming and it made banks balance
sheets look very good.
In the aftermath of the subprime meltdown
in the United States, the criticisms of mark-to-
market
accounting
led
the
International
Accounting Standards Board to form an advi-
sory panel to enhance its guidance on valuing
financial instruments in inactive markets in
times of crisis. Moreover, in the United States
there was a Congressional focus on fair value
accounting which led to a provision in the
Emergency Economic Stabilization Act of
2008, discussed in Chapter 9, that required
the SEC, in consultation with the Federal
Reserve and the U.S. Treasury, to submit a
study of mark-to-market accounting applica-
ble to financial institutions. Who knew that
accounting could get even politicians worked
up!
resources or expertise to keep up with clever people in financial institutions seek-
ing to circumvent the existing regulations.
Financial regulation and supervision are difficult for two other reasons. In the
regulation and supervision game, the devil is in the details. Subtle differences in
the details may have unintended consequences; unless regulators get the regula-
tion and supervision just right, they may be unable to prevent excessive risk tak-
ing. In addition, regulated firms may lobby politicians to lean on regulators and
supervisors to go easy on them. For all these reasons, there is no guarantee that
regulators and supervisors will be successful in promoting a healthy financial sys-
tem. These same problems bedevil financial regulators in other countries, as the
Global box, International Financial Regulation, indicates. Indeed, as we will see,
financial regulation and supervision have not always worked well, leading to
banking crises throughout the world.
Because so many laws regulating the financial system have been passed in
Canada, it is hard to keep track of them all. As a study aid, Table 10-1 lists the
major financial legislation in the twentieth century and its key provisions.
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