Gertrude Tumpel-Gugerell: Elements for intervention on accounting
issues
Speaking notes by Ms Gertrude Tumpel-Gugerell, Member of the Executive Board of the
European Central Bank, at the colloquium "La juste valeur dans tous ses Etats", organised
by the Académie des Sciences et Techniques Comptables et Financières, Paris, 27 April
2010.
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Which are the issues related to the fair value for companies?
Fair value is an appropriate measurement for certain financial instruments, notably those that
are held for trading (i.e. business model is to generate profits by buying/selling in the short
term) and for which reliable market prices are readily available, as well as for derivatives.
Indeed, given that many derivative contracts have a zero cost at inception, fair value
accounting is crucial as it recognises the potential leveraged exposure on the balance sheet.
Fair value accounting mainly raises two issues: first, when to apply fair value measurement
(conceptual considerations) and second, how to apply fair value measurement (operational
challenges).
First, in our view fair value accounting does not provide decision-useful information to
investors if the intention of an entity is to hold the assets until maturity or to settle the
liabilities at their nominal amount at maturity. In these cases, recognising interim fair value
changes simply heightens the volatility of the financial accounts, without providing actual
"information content". This is typically the case for the loan book of commercial banks.
Moreover, the ECB does not agree that an entity is required to record a gain when the fair
value of its own debt falls due to a decrease in its creditworthiness. The rationale being that
the entity could buy back the debt and realise the profit. However, in reality and especially in
times of distress, an entity does not have readily available the extra cash to buy back their
debt. The recognition of such misleading gains was particularly prevalent in the case of
Lehman that used it to net against the mounting losses, which simply blurred the entity's
actual performance. As referred to in the recent book "Too big to fail" by Andrew Sorkin: "It
means that the day before you go bankrupt is the most profitable day in the history of your
company, because you'll say all the debt was worthless. You get to call it revenue. And
literally (...) pay bonuses off this." I think we can all agree that there is something
fundamentally wrong with this argument.
Second, with regard to its application, fair value accounting poses certain operational
challenges, namely when markets become illiquid and reliable market prices are no longer
available. What is the use of marking-to-market when there is no market? The relevance and
reliability of fair values based on market prices require a functioning market where prices
adequately reflect the underlying fundamentals of the financial instrument. When the market
is significantly disrupted, the use of market values may be utterly meaningless. In these
cases, appropriate valuation techniques coupled with adequate guidance on the application
of these techniques are needed in order to arrive at a reasonable estimate of the price at
which an orderly transaction would currently take place between market participants. An
entity should have in place adequate models that have been tested for accuracy in case the
market is severely disrupted. Moreover, in rare circumstances, if the market dynamics are
such that an institution may be forced to change its respective business model (i.e. shifting
from a "day trading" to a "buy and hold" business model), then it should be able to reclassify
financial instruments at amortised cost. These are important lessons to be learnt from the
financial crisis.
Hence the ECB is of the opinion that fair value measurement should only be required if it is
consistent with the institution's business model and the characteristics of the particular
underlying asset or liability.
Which would be the worst drawbacks, if any, deriving from applying fair value in the
light of the events happened in the last two years? Which are the positive aspects?
In my view, the financial crisis has clearly highlighted the heightened pro-cyclicality stemming
from two mutually reinforcing channels in the accounting framework: fair value accounting
and the current loan loss provisioning practices (impairment methodologies).
Fair value accounting - while certainly not being the "root cause" - served as an amplifier of
stress in the financial system. Fair value measurement - by its nature - tends to introduce
pro-cyclicality into the accounting framework. It requires the immediate reflection of
marketrelated information in the financial accounts (thus providing a "snapshot" of the reporting
entity's economic condition). In doing so, all fluctuations in fair value (even if only temporary)
are to be reflected, thereby increasing accounting volatility.
Downward swings in fair valuations of assets cause entities to sell these assets; these "fire
sales" may themselves add to further downward pressure on respective market prices. As a
result, further adjustments to the fair values of these assets become necessary, thereby
perpetuating the "downward dynamics".1 These dynamics may in the end have adverse
implications for the "real economy", e.g. banks may further curb their lending to the economy.
In this context, the potential impact of fair value accounting on behaviour, asset price
dynamics and subsequently on financial stability should not be underestimated.
Pre-crisis provisioning practices delayed the recognition of credit losses inherent in loans.
Accounting rules require a specific trigger event, such as a default in payment to take place
before allowing an entity to create provisions for credit losses. As a result, major write-offs
usually accumulate during severe downturns when the inherent credit losses actually
materialise, adding further stress to the financial system.
Hence, a more forward-looking provisioning methodology should be developed. This has
also been a recommendation of the G20 Leaders. In this context, the ECB welcomes the
recent IASB proposal for an expected cash flow approach. Despite some operational
challenges that need to be resolved before its final adoption, this approach allows for a
timelier recognition of expected credit losses, thereby contributing to mitigating
pro-cyclicality. In this context, it should be noted that the Basel Committee has recently
developed an approach which aims at reducing the complexity of the IASB's approach. The
ECB urges the IASB to work together with the Basel Committee with a view to developing a
workable solution to a more forward-looking provisioning approach.
This is also a good example of where the objectives of high quality accounting and
safeguarding financial stability complement each other.
On that note, let me finally underline that the ECB acknowledges the work of the IASB and
welcomes the progress that has been achieved in the accounting framework. We look
forward to continuing the intense dialogue with the IASB on the remaining phases of the
financial instruments' project, as well as other accounting areas that may be of importance
from a regulatory perspective.
As regards the convergence between the American implementation and the IFRS
rules, which is your general view? More precisely, on which technical/conceptual
points Europe will not give up?
One of the key lessons to be learnt from this crisis is the need for international accounting
convergence. Towards this aim, G20 Leaders have urged accounting standard setters to
develop a single set of high-quality accounting standards.
A global set of accounting standards is desirable from the perspective of both investors and
regulators since it improves the comparability and transparency on a global basis. This
contributes towards sounder investment decisions and thus to a more efficient allocation of
resources as well as overall functioning of capital markets. Moreover, the financial crisis
clearly revealed the shortcomings of different accounting rules on both sides of the Atlantic,
as differences in rules contributed towards a lower degree of confidence in financial
reporting.
For all these reasons, the ECB welcomes the ongoing efforts of the accounting standard
setters to achieve fully compatible, high-quality accounting standards in a direct response to
the G20 request. However, we are concerned to hear that the FASB and the IASB are still far
from reaching a consensus on key accounting concepts, such as the classification and
measurement of financial instruments. The IASB has confirmed a "mixed measurement
model" that measures financial instruments both at amortised cost and fair value. In contrast,
the US standard setter, the FASB, is determined to move towards a "full fair value model",
claiming that only fair value provides decision-useful information to investors.
I have already mentioned in my intervention how the financial crisis has blatantly revealed
the flaws with this measurement and how in certain circumstances, namely when markets
are dislocated, applying full fair value accounting to the financial statements of the banking
sector raises financial stability concerns and does not provide decision-useful information to
investors.
Just to re-emphasise, the ECB strongly opposes a full fair value approach. In this context,
convergence should not come at the expense of high-quality accounting standards.
Finally, with regard to recent assertions made by the IASB and FASB that convergence is on
track, I would like to highlight that we are not so optimistic. In this regard, putting in place a
reconciliation mechanism that simply discloses figures at amortised cost and fair value for
each item on the balance sheet would certainly not achieve the aim of convergence.
As regards governance, which improvements do you envisage in relation to the
elaboration of accounting rules?
First, I would like to stress that the ECB fully supports the concept of "independent
accounting standard setting". In their April 2009 DECLARATION ON STRENGTHENING
THE FINANCIAL SYSTEM, when identifying the main areas of concern in the accounting
area, the Leaders of the G20 never challenged this concept.
Second, the ECB very much welcomes the recent efforts of the IASB with a view to
enhancing their public accountability. We appreciate the open dialogue between the IASB
and various stakeholders, including prudential supervisors, on various accounting issues.
Having said that, the ECB would still like to see accounting standard setters take better
account of financial stability implications when revising existing or creating new accounting
standards, as for instance indicated by the IASB on the occasion of setting up the "enhanced
technical dialogue" with prudential supervisors in 2009. One concrete and important area
where the IASB can prove that it takes duly into account financial stability implications would
be the on-going discussions on introducing more forward-looking provisioning.
In this sense, the ECB looks forward to continuing the close dialogue with the IASB on the
accounting projects that lie ahead.
More generally, please indicate two essential measures for financial regulation in the
current debate.
The ECB firmly believes that momentum should be maintained with regard to the global
regulatory reform agenda. We need to ensure we put in place a regulatory framework that
will enhance the resilience and stability of the global financial system. Under the aegis of the
G20, the international community has agreed on a comprehensive set of measures that
reflect a substantive revamp of the regulatory framework. Going forward, I would mention
three key priority areas.
First, the global community should commit to implementing the so-called Basel III proposals
on capital and liquidity issued in December of last year. The ECB supports these proposals
which are designed to put banks in the position to better withstand the effects of future
crises. At the same time, it is crucial to carefully assess the macro-economic impact of the
measures. In this context, the outcome of the quantitative impact assessment that is
currently being conducted needs to be awaited before taking any final decisions.
Inappropriate calibration of the measures may impact on the provision of credit to the real
economy. This is particularly relevant for the EU financial system which is more
bankdependent and where the substitutability between market finance and bank finance is more
limited when compared to, for example, the US. The main challenge consists in ensuring a
more resilient and stable financial system that neither compromises economic recovery nor
unduly impinges on financial innovation.
Second, we need to ensure that we effectively capture all systemically important financial
institutions, products, markets and infrastructures within the scope of regulation. One of the
lessons from the crisis was the need to make the shadow banking sector more transparent.
This becomes more urgent as we tighten the regulatory net for the banking sector. Otherwise
we may simply shift risks to unregulated or more loosely regulated entities.
In this respect let me mention the OTC derivative markets. These markets should be subject
to greater transparency by promoting the reporting of non-centralised trades to trade
repositories. Additionally, we should promote the clearing of eligible OTC derivatives
transactions through central counterparties, which should be themselves subject to high
prudential and operational standards.
Finally, we need to effectively address the risks posed by systemically important financial
institutions. In particular, we need to define a regulatory framework addressing the risks
posed by large and complex financial institutions, and to discuss possible measures aimed to
ensure a smooth winding-up of ailing systemically important financial institutions. It is crucial
that a consistent framework is agreed at international level to avoid conflicting national
regimes applied to multinational institutions and regulatory arbitrage. In this context, I
strongly support the current work being carried out by the Financial Stability Board and the
Basel Committee.