The accountants let us down.
That is one of the clear lessons of the financial crisis that drove the world into a deep recession. We now know the major banks were hiding dubious assets off their balance sheets and stretching rules if not breaking them. We know that their capital was woefully inadequate for the risks they were taking.
Efforts are now being made to improve the rules, with some success. But banks have persuaded politicians on both sides of the Atlantic that the real problem came not when their financial inadequacies were obscured by bad accounting, but when they were revealed as the losses mounted. “There were important aspects of our entire financial system that were operating like a Wild West show, huge unregulated opaque markets,” said the man whose job was to write the accounting rules, Robert H. Herz, the chairman of the Financial Accounting Standards Board. “The crisis highlighted how important better transparency around that system is,” Mr. Herz added in an interview this week. “I would hope that would be a major lesson learned or relearned.”
Unfortunately, some seem to have learned exactly the opposite lesson. Accounting rule makers at FASB and its international equivalent, the International Accounting Standards Board, have been lambasted for efforts to improve transparency by forcing banks to disclose what their dodgy assets are actually worth, as opposed to what the banks think they should be worth.
Both boards have tried to resist, but have been forced by political pressure to back down on some specifics. In the case of FASB, the retreat took a few weeks after Mr. Herz was ordered to act at an extraordinary Congressional hearing. The international board was given a long weekend to retreat, with the European Commission threatening to impose its own rules if the board did not cave in. Both boards tried to reduce the damage by forcing more disclosures, but it is unclear how much good that will do. Neither was willing to defy the politicians.
It is unfortunate that there are significant differences between the American and international rules on how to determine fair values of financial assets. That has enabled banks on both sides of the Atlantic to demand that they get the best of both worlds. Pleas for a level playing field have resonated in Washington and Brussels.
The banks have argued that market values can be misleading, and that their own estimates of the eventual cash flow from assets are more realistic than what they — or others — will now pay for those assets. The rules already allowed them to ignore so called “distress sales” in assessing fair value, but the banks pushed to broaden that exemption in the United States, while in Europe they got the regulators to allow them to retroactively stop calculating market value for assets they said they did not intend to sell.
Behind the scenes, there is a battle pitting securities regulators — who instinctively favor disclosure — against banking regulators, who fear there are times when disclosure could make a bad situation worse.
The securities regulators argue that accounting should do its best to report the actual financial condition of a company. If the banking regulators want to allow banks to use different rules in calculating capital — rules that would not require marking down assets, for example — then they can do so without depriving investors of important information.
But that information could scare those investors, and set off the kind of panic that brought down Lehman Brothers a year ago.
It is the job of banking regulators to keep their institutions healthy, and that effort can only be helped by accounting that reveals problems early. But if the banks do get into trouble, some regulators would prefer to maintain the appearance of prosperity while efforts are made to fix the problems quietly.
It can be argued that approach worked nearly 20 years ago, when some banks were allowed to pretend they were solvent after the Latin American debt crisis, and were able to earn their way out of the problem over the ensuing decade.
Had a different course been chosen in the early 1990s, Citibank might have vanished. Given what has happened to Citi in this crisis, it is not clear if that would have been a good or bad outcome.
The accounting rules on financial assets were, and are, a confusing mess, with the same loan getting very different accounting based on whether or not it had been packaged as part of a security. In some cases, banks could not take loan losses as early as they should have, even if they wished to do so. As financial complexity increased, rule makers struggled to keep up, and were not always successful.
Efforts to fix those rules are under way. Accounting for loans is likely to be improved. But in the crucial area of fair value accounting, the American and international boards are not moving in tandem. The international board is delaying some issues as it rushes to get a rule out this year that will clarify when banks can ignore fair value. The American group is taking a more unified, and slower, approach. By not moving together, they run the risk of a race to the bottom, with investors the losers.
Fair value is not the only important issue. Some of the biggest and worst surprises of the financial crisis came when banks suffered large losses from assets that they had not even reported they owned. “With the benefit of hindsight, we know that standards were not complied with,” said Mr. Herz, regarding the rules on which assets could be left off balance sheets.
Those rules hinged largely on something called “qualified special-purpose entities,” or Q’s for short. If a bank set up a Q so that it would operate automatically, with others owning the securities it issued, the bank could get the assets off its own balance sheet.
As the Securities and Exchange Commission pointed out in a report to Congress, banks were able to greatly expand the scope of Q’s, “beyond the simple pass-through entities envisioned by the FASB.”
The S.E.C., in that report, concluded that because so many problems were being caused by the development of structured transactions motivated by accounting considerations, “improvement in transparency and comparability across issuers can perhaps most directly and quickly be accomplished by eliminating the use of such structured transactions.”
FASB now is moving to get rid of Q’s, a category that the international board never accepted to begin with. Off-balance sheet accounting is being cleaned up.
But that move comes years too late. The S.E.C. report quoted above was issued in 2005, but nothing happened as a result. “If they had gone after that at the S.E.C., it might have taken a couple of quarts of gasoline away from the fire,” said Jack T. Ciesielski, whose newsletter, The Analyst’s Accounting Observer, repeatedly warned of off-balance-sheet problems.
The fights over bank accounting are taking place against the backdrop of the S.E.C. trying to decide whether and when to move the United States to international accounting standards, and as the two boards seek to converge on one set of accounting rules.
Mr. Ciesielski fears convergence could lead to acceptance of the weakest standards for banks. But without convergence, the S.E.C. will have no standing to oversee application of international standards, or to act as a counterweight if European politicians try to order even weaker standards to protect their banks.