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    Fair value accounting, fragile bank balance sheets and...
    research summary posted July 21, 2015 by Jennifer M Mueller-Phillips, tagged 08.0 Auditing Procedures – Nature, Timing and Extent, 08.06 Earnings Management – Detection and Response 
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    Title:
    Fair value accounting, fragile bank balance sheets and crisis: A model.
    Practical Implications:

    The model offers a simple explanation of why the world, for so long after the height of the global financial crisis, is still mired in slow growth. During a prolonged and excessive boom bank profits and capital were materially increased by unrealized FVA profits. These profits justified the pay-out of liquid assets weakening the financial system. The additional capital further justified more debt financed asset expansion. With the crisis bank management realized that these unrealized capital items were not permanent. Management was able to postpone the recognition of FVA losses by using the flexibility inherent in FVA regulations, but lending was slowed to a point reflective of “safe” capital levels. Lending activity will stay subdued until all of these marked-up items have been worked off banks’ balance sheets.

    Citation:

    de Jager, P. 2014. Fair value accounting, fragile bank balance sheets and crisis: A model. Accounting, Organizations & Society 39 (2): 97-116.

    Keywords:
    fair value accounting, financial crises, financial statements, transmission mechanism, earnings management
    Purpose of the Study:

    The primary objective of this paper is to provide a reasonable alternative perspective on the relationship between fair value accounting (FVA) and the global financial crisis; a perspective that focuses on finding the link before the crisis (during the upswing) and one that reminds accountants that in banking, accounting is more than just a messenger: when bank deposits are created by accounting entries, accounting is money. To this end, a model will be developed in this paper that demonstrates the link between accounting and bank capital regulations and helps to aid understanding of the global financial crisis.

    The nexus of the model to be developed will be the impact of FVA on the regulatory capital of banks. Not all FVA entries impact banks’ regulatory capital. Thus, only FVA entries related to trading instruments or instruments designated at fair value are relevant for the model when values increase. FVA increases in the value of available-for-sale instruments are not covered because those increases would be excluded from regulatory capital. When values decrease, other-than-temporary-impairments of available-for-sale instruments become relevant as these are posted through profit and loss.

    Design/Method/ Approach:

     The author uses analytical modeling to conclude on the questions of interest.

    Findings:

    The model demonstrates the expansionary impulse generated when FVA increases bank regulatory capital. It can be argued that the same expansionary impulse will result from other accounting entries that also increase regulatory capital. FVA’s impact differs in two important aspects. First, FVA impacts regulatory capital much faster and more materially than other accounting entries that need time to impact retained earnings. It is the speed of the feedback process that matters. The second way in which the capital increase from FVA differs from increases caused by other accounting entries is that these alternatives will not result in the replacement of liquid assets in bank capital with riskier FVA gains; FVA profits do not provide liquidity that can fund dividends and remuneration payments.

    Another characteristic of the model is that it is incomplete. Banks do not just lend money due to the interaction between FVA and their capital ratios. The real economy has a need for credit before the supply of credit is considered. In the same way it is not argued in this paper that FVA is the primary or sole reason behind the cyclicality of financial capitalism.

    Category:
    Auditing Procedures - Nature - Timing and Extent
    Sub-category:
    Earnings Management – Detection and Response