Marktomarket accounting and liquidity pricing policy
Create account Marktomarket accounting and liquidity pricing policy Subscribe. Avinash Persaud 11 October But a blanket suspension would be counter-productive. Crises are marktomarket accounting and liquidity pricing policy when uncertainty quickly turns to panic. Now is not the time to increase uncertainty by changing accounting standards. This column proposes an alternative: Observers elsewhere support a suspension of this accounting rule.
It is a widespread view, especially amongst bankers, that International Financial Reporting Standards IFRS on fair value accounting compounded the recent financial crisis. Application of the IAS 39 rule that governs loan-loss provisions and extends mark-to-market valuation of assets meant that when credit prices fell sharply and asset values were written down, banks were forced to sell assets and pull back credit lines to raise capital, which lowered asset prices further, causing more write downs and more capital losses.
The jump in mark-to-market volatility compounded the problem by keeping buyers away. When lower prices do not drag out bargain hunters, but instead, more sellers, liquidity vanishes into what I have called a Liquidity Black Hole. Consequently, prices have plummeted far below any measure determined by the risk of default.
These prices represent liquidity-risk, not credit-risk. But a blanket suspension of mark-to-market rules would be counter-productive. Crises are a time when rumours are rife and uncertainty quickly turns to panic.
It is not the time to increase uncertainty by changing accounting standards. Moreover, this would work against future crisis avoidance. Financial crashes are not random: Offering forbearance from mark-to-market accounting rules during a crisis, yet using these rules during the preceding boom, would promote excessive lending and leverage in the good marktomarket accounting and liquidity pricing policy. This asymmetry in the application of rules could contribute to more frequent and severe crashes.
There is another important issue that points the way to resolution of this issue. Under Basle I, the mechanism by which falling prices of assets lead to further declines in the price of assets was driven in large part by value accounting of assets. Under Basle II, market prices enter into both valuation and risk assessment.
The very philosophy of Basle II — risk sensitivity — is about incorporating market prices into the assessment and response to risk. It should be no surprise that putting market prices at the heart of the system whose purpose is to avoid market failure will lead to systemic collapse.
But the point is that simply changing the value accounting, but continuing to use market prices and their proxies such as credit ratings in assessment of the riskiness of assets will not pull us out of the liquidity black hole. From a risk management perspective, the problem with the current value accounting rules is that the focus is on the asset: We have seen how asset liquidity and holder intentions can change rapidly in a crisis leading to an increasingly artificial view of value and solvency.
We should instead focus on the funding liquidity of the asset. Where assets are funded with short-term liabilities, then whatever the perceived liquidity or intentions of the asset owners, it is appropriate to mark the value of that asset to market in case funding dries up and the assets need to be sold tomorrow.
But where assets are funded with long-term liabilities or set against long-term liabilities, as is typically the case with a young pension fund, then marking asset values to market is not appropriate and can lead to an artificial view of risk and investment decisions based on a risk that is not important to the holder.
The valuation "window" and the duration of risk management should be linked directly to the maturity of funding. The scope for banks to switch away from mark-to-market accounting under my proposal will be less than they are marktomarket accounting and liquidity pricing policy employing by re-classifying assets from trading to hold to maturity. But the scope this marktomarket accounting and liquidity pricing policy would be more credible for being less marktomarket accounting and liquidity pricing policy.
To date crisis management efforts have been focused on trying to marktomarket accounting and liquidity pricing policy the selling of assets: The EMU after the euro crisis: Insights from a new eBook.
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