Institutions and Accounting Practices after the Financial Crisis

International Perspective

Victoria Krivogorsky, Victoria Krivogorsky

• Publisher: Routledge
• Year: 2019
• ISBN:
  9781315468631
• Edition: 1
• Topic: Business
• Subtopic: International Accounting
• Index: Business

Financial globalization paired with the relaxation of constraints on capital flows between countries before the 2008 crisis, increased merger activities among the World's largest stock exchanges. The financial crisis of 2008 had a severe impact on the development of equity markets, corporate financial stability, and corporate governance, and a multi-step approach is needed to fully appreciate the causes and effects of this event. This book engages the separate strands of literature to advance a more holistic understanding of whether and how the national institutional environments in selected countries around the world has been changed after the crisis.

Institutions and Accounting Practices after the Financial Crisis: International Perspective sets out a framework for the analysis of institutional environments and accounting practices in in selected countries around the world during the pre-crisis period, followed by an examination of the impact of the crisis. It scrutinizes the changing roles of debt and equity markets; the shift in accounting practices and capital financing choices due to the economic downturn; and the lessons that can be obtained from the financial crisis, while considering the institutional architecture of international business environments. This ongoing process of integration and globalization increases interdependence between world markets, and allows shocks to propagate across national and continental lines, making the understanding of international markets vitally important to American investors.

Aimed at primarily researchers, academics and students in the fields of international accounting, management and finance, Institutions and Accounting Practices after the Financial Crisis: International Perspective will additionally be of value to practitioners and policy makers, supplying them with information regarding the changes in accounting practices and risk evaluation due to the crisis.

Part 1

1
The Causes of the 2008 Financial Crisis

The Prospects of IFRS Adoption in the US

Victoria Krivogorsky

Introduction

What was a primary cause(s) of the latest financial crisis? According to Steve Forbes, chairman of Forbes Media, mark-to-market accounting was “the principal reason” that the US financial system seized up in 2008. In particular, he said that “the crisis never would have become so unprecedentedly destructive but for a seemingly arcane accounting principle called mark-to-market, or fair value, accounting.”¹ Mr. Forbes’ critical assessment of the mark-to-market approach included but was not limited to the following:

• Writing down investments reduces a bank’s “regulatory capital,” which in turn causes the reduction of lending.
• Reduced lending by banks triggers a chain of events: lack of investment precipitates higher unemployment, which in turn brings about higher loan default rates, which causes the fair value of bank investments to decline even further.
• The accounting rules on fair value aggravate the condition by employing an illiquidity discount to “subprime securities and other suspect assets” even if there has been no direct substantiation of impairment.

His qualified opinion has been supported and repeated numerous times by his colleagues, the Wall Street Journal, and members of the US Congress alike. For example, the chief economist at First Trust Advisors, Brian Wes-bury, along with Steve Forbes, argues that marking to market impelled many banks toward insolvency and drove them to unload assets at fire-sale prices, which then caused values to fall even further.² In his piece “Why Mark-To-Market Accounting Rules Must Die,” co-authored with Robert Stain, he advocates for an immediate suspension of FASB 157.³ Particularly, it was argued that because markets are forward-looking, the existing accounting rules force banks to write off losses before they even happen. In other words, the market overstates current and future losses. The accounting rules force banks to take artificial hits to capital without reference to the actual performance of loans. In this regard, fair value accounting, they believe, undermines the banking system by wiping out capital from the books that in turn starts a chain of negative events. Specifically, it increases the odds of asset fire sales that make markets even less liquid; bad loans multiply, the investment banks fail, and the government proposes bailouts. The latter drives prices down even further, fueling violent downward economic spiral.⁴ As a result, the “mark-to-market accounting rules have turned a large problem into a humongous one. A vast majority of mortgages, corporate bonds, and structured debts are still performing. But because the market is frozen, the prices of these assets have fallen below their true value.”⁵ Persuaded by such arguments, some politicians in the US and Europe have called for the suspension of fair value accounting in favor of historical cost accounting, according to which assets are generally valued at original cost or purchase price.⁶ Mark-to-market accounting continues to have its supporters, who are equally unwavering. Among others, there has been an opinion suggesting that accounting simply delivers the news to the market. Professor Lisa Koonce from the University of Texas wrote in Texas magazine:

This is simply a case of blaming the messenger. Fair value accounting is not the cause of the current crisis. Rather, it communicated the effects of such bad decisions as granting subprime loans and writing credit default swaps. The alternative, keeping those loans on the books at their original amounts, is akin to ignoring reality.

Following the same line of logic, the Financial Accounting Standards Board (FASB) investment advisory committee asserted that fair value approach is all the more necessary in today’s environment, and that “it is especially critical that fair value information be available to capital providers and other users of financial statements in periods of market turmoil accompanied by liquidity crunches.” In this view, if banks did not mark their bonds to market, investors would be very uncertain about asset values and therefore reluctant to help recapitalize troubled institutions.⁷

Another accounting regulation blamed for the financial crisis is the accounting for derivatives. It was publicly stated in literature and press that derivative financial instruments had rendered the current approach to banking regulation obsolete.⁸ For example, let’s assume that a financial institution holds only one “investment.” It is an interest rate swap, with a notional amount of $50 billion. The historical cost of entering into the swap was zero, and its current fair value is $1 billion. Also, assume that the bank has liabilities of $0.5 billion. With a debt/asset ratio of 50%, this bank can be technically considered as well capitalized? However, in a case when interest rates move insignificantly in the wrong direction, a $1 billion asset could transform into a $10 billion liability. Moreover, the probability of that occurring could be 50% or more.

As the result, the reliability of the capitalization ratios based on US GAAP and their ability to measure banks financial strength had been questioned, especially after derivatives hit the bank balance sheets in a big way. The supporters of this point of view rejected the existing opinion that policies similar to those of Franklin D. Roosevelt from the time of the significant depression might save the day.⁹ FDR had no derivatives problem, they argued, and therefore old logic and conceptual approaches won’t work in the new economic environment.

Supporters of all points of view were united in believing that the US Congress should hold hearings related to financial reform. They were all in favor of coming to an understanding that if a regulatory modernization adequately addresses only a single risk, it is destined to fail. Every potential threat to the financial system must be an integral part of the comprehensive legislative response to the economic crisis. Even if financial reporting did play some role in fueling the crisis, changing accounting rules that cover an insignificant percentage of assets that banks mark to market is probably not going to make a big difference. It seems that along with looking into the notion of capital adequacy based on capitalization ratios, it is also essential to rest...