A new academic study argues that proposed changes in fair value measurement by the Financial Accounting Standards Board would make it harder to assess the financial soundness of banks, and it’s co-authored by a member of the FASB board.

In 2010, FASB proposed that in most instances institutions value their financial assets and liabilities to reflect their present market worth and not just their adjusted historic cost (the primary basis for valuation under generally accepted accounting principles). Thus, banks that were effectively insolvent—with severely devalued mortgages or securities on their books, whether from a slumping economy or plain mismanagement—would no longer be able to hide their problems by delaying write-down of their holdings to "fair" or current market value.

After massive protests from the banking industry, FASB took a preliminary vote in January 2011 to modify the proposal. This February it issued an update, "Recognition and Measurement of Financial Assets and Financial Liabilities," which considerably reduces the role of fair value accounting from what it envisioned in 2010 (see FASB Revises Proposed Changes in Financial Instruments Accounting Standards). The 90-day period for public comment on the newly proposed standard recently ended, and, after additional redeliberations, it could be finalized by the end of this year.

In a separate controversial proposal on impaired loans and credit losses, FASB parted ways in its convergence efforts with the International Accounting Standards Board on their financial instruments project (see IASB Diverges from FASB in Revised Loan Loss Proposals and FASB Proposes More Timely Recognition of Expected Credit Losses). FASB has extended the deadline for commenting on the proposal until May 31 and then hopes to eventually reach a converged solution with the IASB after the two boards compare the feedback they received from their constituents (see FASB Extends Comment Deadline on Credit Loss Proposal).

The new academic study may provide fodder for critics of both of FASB’s proposals. The study found that fair value accounting is 25 percent more accurate in gauging banks’ credit risk than either GAAP or a formula called Tier 1 Capital that is used by bank regulators to assess financial safety and soundness. The study, whose authors include FASB board member Thomas J. Linsmeier, also found that fair-value accounting to be superior to the other two metrics in anticipating bank failure two or three years before it occurs.

The study will appear in the forthcoming issue of The Accounting Review, published by the American Accounting Association.

In addition to Dr. Linsmeier, who was one of two FASB board members to dissent from the recently issued standards update on recognition and measurement of financial assets and liabilities, the research was carried out by Elizabeth Blankespoor of Stanford University, Kathy Petroni of Michigan State University and Catherine Shakespeare of the University of Michigan.

“Overall, our study provides evidence to standard setters that leverage ratios based on fair values of all financial instruments describe a bank's credit risk better than GAAP or Tier 1 Capital leverage ratios,” the paper concluded. “This evidence suggests that banks’ financial statements with financial instruments measured at fair values, including loans, deposits, debt, and held-to-maturity securities, are more descriptive of the credit risk inherent in the business model of banks than the current GAAP financial statements.”

The authors also expressed skepticism about claims of the American Bankers Association “based on interviews with bank financial-statement-user groups” that users are satisfied with financial statements as currently produced. In the authors’ words, “Our study should be of interest to those interviewed because we provide large-sample evidence that leverage measured using fair values for all financial instruments is more descriptive of credit risk than leverage calculated under the currently reported [GAAP] model.”

The findings derive from an analysis of the relationship between two measures of credit risk—one conveying the assessment of the bond market and the other related to different leverage measures based on fair value, GAAP, or Tier 1 Capital.

For the market-based measure, the researchers collected yield spreads on 1,861 bonds issued by 46 bank holding companies between 1998 and 2010, yield spreads being the amount that interest rates on the banks' securities exceeded the rates on Treasury bonds. They then analyzed the relationship between yield spreads in a given year and the three different measures of banks' leverage in that year and found the two to be most closely correlated when assets and liabilities were calculated on the basis of fair value rather than by the two other measures. They found this to “hold for both complex banks and banks with more traditional books of business, primarily loans and deposits, and within both the expansionary and recessionary phases of our test period.”

In addition to analyzing the relationship of leverage measures to market perceptions, the researchers probed how well the different leverage measures anticipated actual failures among 1,067 banks, 53 of which declared bankruptcy, from 1997 through 2009. They found that “both two and three years prior to failure, fair-value leverage dominates the other two leverage measures in predicting failure...This demonstrates that leverage based on fair value provides the earliest signal of financial trouble.”

In dissenting from the recent proposed standards update from the FASB on recognition and measurement of financial assets and financial liabilities, Dr. Linsmeier joined fellow board member Marc Siegel in contending that “the proposed Update would be more lenient than current U.S. GAAP” and in expressing particular concern that it "would not require nonpublic financial institutions to disclose fair-value information for any financial instruments measured at amortized cost.” In conclusion, they expressed doubt that the proposed update “would represent a significant improvement to current U.S. GAAP and would provide investors with decision-useful information.”

Two years ago, in an article in Accounting Horizons, another journal of the American Accounting Association, Linsmeier looked past the recent world recession and observed that “the limitations of historical cost accounting were glaringly apparent in the other two major global banking crises of the past 25 years—the U.S. Savings and Loan (S&L) crisis in the late 1980s and early 1990s and the Japanese banking crisis of the 1990s and 2000s.”

Linsmeier added, “The best way to ensure that regulators, investors and the market at large have a full understanding of banks’ true financial conditions is to include changes in the value of financial instruments over time in financial statements, along with historical cost figures. If we are to guard against unsustainable lending practices that can lead to systemic crises, fair-value accounting should be adopted for all financial instruments as part of the solution.”

A FASB spokesman declined to comment on the research study co-authored by Linsmeier, but did respond to a separate criticism of FASB’s credit impairment proposals from the head of the Credit Union National Association. CUNA warned Wednesday that the proposal to change the methodology for recognizing credit impairment would be detrimental to the credit union system and could have serious, unintended consequences for borrowers and the economy.

The FASB proposal is “the most critical regulatory concern credit unions have faced in quite some time, including rules or proposals that have been issued under the Dodd-Frank Wall Street Reform and Consumer Protection Act,” CUNA president and CEO Bill Cheney wrote in a comment letter to FASB.

He pointed out that FASB’s proposed accounting standards update regarding financial reporting of expected credit losses on loans and other financial assets held by financial institutions, including credit unions would utilize a single “expected loss” measurement for the recognition of credit losses, replacing the multiple existing impairment models in U.S. GAAP that generally use an “incurred loss” approach.

Under the proposal, the reporting entity would be required to estimate the cash flows that it does not expect to collect, using all available information, including historical experience and forecasts about the future.

CUNA questioned whether the proposal would achieve FASB’s stated objectives and how the proposal would be reconciled with the proposed approach from the IASB.

“Some have concluded that the current methodology for recognizing credit losses did not identify such losses at the largest financial institutions soon enough leading up to and during the financial crisis,” Cheney wrote. “However, there is no evidence that the current system is not working well for smaller institutions, including credit unions. After reviewing the proposal in detail with our members, accountants and others, CUNA strongly opposes the proposal and urges the FASB not to proceed with the accounting standards update as issued for comments. If dropping the proposal is not feasible, CUNA urges the FASB to work with the credit union system to develop credit loss reporting standards for credit unions, separate from those for publicly traded companies, that will reflect the unique business model of credit unions while ensuring credit loss issues are reported appropriately.”

In response to the comment letter, FASB spokesman Robert Stewart wrote, “One of the lessons learned from the global financial crisis of 2008 is that investors need more timely financial reporting of credit losses on loans and other financial instruments. Waiting until significant credit deterioration occurs before recognizing a loss defeats the purpose of moving from an incurred loss model to an expected loss model. The FASB’s proposed model is intended to fix the problem that the Financial Crisis Advisory Group (FCAG) identified with current GAAP related to the delayed recognition of credit losses.

“The FASB model and the IASB model both would require that expected credit losses be estimated based on past events, current conditions and reasonable and supportable forecasts about the future,” Stewart pointed out. “Furthermore, both models ultimately will require the same reserve; the only difference is that the FASB model will require it sooner so that initially, it will be larger. Under the FASB model, an organization would record its current estimate of expected credit losses every period.  The IASB model would record a portion of the expected credit losses until a significant credit deterioration has occurred, at which point the full estimate of expected credit losses would be recognized. While estimating credit losses involves significant judgment under any accounting approach, the FASB believes that using a consistent measurement principle and removing any threshold for recognition reduces management's discretion as to when expected losses should be recognized.

“The FASB encourages stakeholders to share their views on this important topic,” Stewart added. “We will consider the feedback received on our proposal, as well as the input the IASB receives on its proposed model. This feedback will help us determine if there are areas where we can develop a common standard.”

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