236 PA R T I I I FYI Financial Institutions Mark-to-Market Accounting and Financial Stability The controversy over mark-to-market accounting has made accounting a hot topic Markto-market accounting was made standard practice in the accounting industry in the United States in 1993 U.S Generally Accepted Accounting Principles (GAAP) established a number of ways for measuring fair value, depending on whether a financial instrument is traded on an active market or in the absence of an active market Canadian GAAP are similar to U.S GAAP, as well as to standards in effect in those countries (approximately 110) that have adopted a set of global standards, known as International Financial Reporting Standards (IFRS), developed by the International Accounting Standards Board (IASB) The rationale behind mark-to-market accounting is that market prices provide a better basis for estimating the true value of assets, and hence capital, in the firm Before mark-to-market accounting, firms relied on the traditional historical-cost (book value) basis in which the value of an asset is set at its initial purchase price The problem with historical-cost accounting is that changes in the value of assets and liabilities because of changes in interest rates or default are not reflected in the calculation of the firm s equity capital Yet changes in the market value of assets and liabilities and hence changes in the market value of equity capital are what indicates if a firm is in good shape, or alternatively, if it is getting into trouble and may therefore be more susceptible to moral hazard Mark-to-market accounting, however, is subject to a major flaw At times markets stop working, as occurred during the subprime financial crisis The price of an asset sold at a time of financial distress does not reflect its fundamental value That is, the fire-sale liquidation value of an asset can at times be well below the present value of its expected future cash flows Many people, particularly bankers, criticized mark-to-market accounting during the subprime financial crisis, claiming that it was an important factor driving the crisis They claim that the seizing up of the markets led to market prices being well below fundamental values Since markto-market accounting requires that the financial firms assets be marked down in value, this markdown creates a shortfall in capital that leads to a cutback in lending, which causes a further deterioration in asset prices, which in turn causes a further cutback in lending The resulting adverse feedback loop can then make a financial crisis even worse Although the criticisms of mark-to-market accounting have some validity, some of the criticism by bankers is self-serving The criticism was made only when asset values were falling, when mark-to-market accounting was painting a bleaker picture of banks balance sheets, as opposed to when asset prices were booming and it made banks balance sheets look very good In the aftermath of the subprime meltdown in the United States, the criticisms of mark-tomarket accounting led the International Accounting Standards Board to form an advisory panel to enhance its guidance on valuing financial instruments in inactive markets in times of crisis Moreover, in the United States there was a Congressional focus on fair value accounting which led to a provision in the Emergency Economic Stabilization Act of 2008, discussed in Chapter 9, that required the SEC, in consultation with the Federal Reserve and the U.S Treasury, to submit a study of mark-to-market accounting applicable to financial institutions Who knew that accounting could get even politicians worked up!