Sunday, April 5, 2009

From "marked to market" to "marked to model"!

The global financial markets and the world economy may be going through its worst phase in decades and by now the culprits - products of opaque financial engineering and greedy bankers, investors and borrowers - are well established. It was therefore natural to expect more stringent and conservative regulatory norms and standards, that would presume a healthy suspicion of the ideologies and premises that undergrid the last two decades of unfrettered play of markets forces in the global financial system. The tough talk on stress tests for the banking sector bailout plan had also raised hopes of stronger and more intrusive regulations of the financial markets.

It is in this context that we need to see the interesting decision of the US FASB to bow to pressure from American Bankers Association (ABA) and change accounting rules to allow banks to report higher profits by assuming that the securities are worth more than their present market values by "marking their assets to a model". The ABA had argued that as the financial markets have tanked, the market prices of many derivative securities have plunged to fractions of their original prices, forced banks to write down their assets, led to margin calls, triggered off massive de-leveraging, report huge losses, and thereby set in motion a vicious downward spiral. All this in turn makes it difficult for banks to raise capital. They therefore argue that banks should be given the flexibility to value their assets at their normal or true values, than at the distressed market prices.

However, critics claim that the change could further damage the credibility of financial institutions and further moral hazard by enabling them to mark up the values of "toxic assets" and avoid recognizing losses from bad loans they have made. As James Kwak writes, accounting rules are expected to embody the principles of conservatism and choose the plausibly pessimistic rules, whereas the FASB rule change enables banks to take the optimistic route.

Further, by permitting the valuation of asset prices based on banks’ internal judgment and their own models, the new rules introduces the possibility of each bank applying different criteria to value their assets. To that extent, this is regression from even the flawed Mark to Market (MTM) (of "fair" market value) model of valuation, where investors were assured of atleast a transparent market price driven valuation system. We therefore get less information and more uncertainty.

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