Why do bankers oppose the use of fair value?

Implications: Claiming a "mixed attribute" accounting model provides a better picture of a company's business and earnings engine, bank trade groups blast full fair value. The bank trade groups argue that periodic updating to fair value would lessen the predictive value of future cash flows.  They also argue that “a mixed measurement model is essential for the faithful representation of an entity’s business model and how it generates earnings.”   

Analysis:   The American Bankers Association (ABA) and its international counterpart, the International Banking Federation (IBFed) argue that requiring “full fair value” measurement of financial assets and liabilities is not relevant.  Currently, some financial instruments are stated at fair value under International Financial Reporting Standards and Statement of Financial Accounting (SFAS) No 159, The Fair Value Option for Financial Assets and Financial Liabilities.  
 
 “Instead, bankers prefer a mixed-attribute financial reporting model …” Under a mixed-attribute model some assets like investments in debt securities are stated at fair value and others perhaps at original cost modified for unamortized discount or premium.  

The article discusses an example of valuing a loan portfolio at amortized cost.  IBFED argues that periodic updating to fair value would lessen the predictive value of future cash flows.  They also argue that “a mixed measurement model is essential for the faithful representation of an entity’s business model and how it generates earnings.”   

Obviously, the best predictor of the future cash flows from a loan portfolio is its fair value. Also, the mixed-attribute model is not representative of the economics of the reporting entity.  In time, historical costs are irrelevant in assessing financial condition. 
 
Further, reporting financial assets using a mixed attribute model while reporting related financial liabilities at fair value increases earnings volatility.  To mitigate that volatility companies must use complex hedge accounting through derivatives.  

The banking industry opposed the exposure draft of what became SFAS Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities. To obtain “general acceptance,” FASB acquiesced to the banking lobby and issued a Statement that was and is, illogical.  Under SFAS 115 investments in debt securities are classified into one of three categories, trading, available for sale or held-to-maturity.  Debt securities classified as trading are stated at fair value in the balance sheet with the change in unrealized gains or losses reflected in the income statement.  Debt securities classified as available for sale are also stated at fair value on the balance sheet. However, the change in unrealized gains or losses is left out of the income statement. (The changes in fair value become part of comprehensive income in stockholders’ equity). Finally, debt securities classified as held-to-maturity are reported at amortized cost.  The change in unrealized gains or losses for these securities is ignored.  

Under SFAS 159, an entity may “choose to measure many financial instruments and certain other items at fair value that are not currently required to be measured at fair value.” This statement applies to financial assets and liabilities. Financial assets include for example, cash, evidence of ownership interest in an entity and investments in debt securities.  Financial assets also include contracts that convey to one entity a right to receive cash or other financial instrument from another entity.  

In some instances, some financial assets will not be stated at fair value because the choice is made instrument by instrument.  However, once the choice is made, it is irrevocable.   

If the fair value choice is made, the change in unrealized gains and losses at each reporting date must be shown in the income statement.  Also, SFAS 159 requires disclosures including management’s reasons for electing or partially electing the fair value option.  In addition, the entity must disclose what the affect on earnings would have been using fair value rather than another method.  For example banks may elect not to measure the value of their loan portfolio using fair value but they will still have to disclose what the affect on earnings would be.  

In an IBFED report, “Accounting for Financial Instruments Conceptual Paper,” they argue for a more useful way to measure the real financial condition and value of assets and liabilities [underline mine]. Somehow measuring investments in debt securities at an arbitrary amortized cost is a better measure than fair value.   Further, financial condition is best measured by adding some assets measured at fair value to other assets measured at anything but fair value and then subtracting from that sum its liabilities.  The argument is at best bizarre and obviously dishonest.  For example, do you think you could get a loan from your banker using anything other than fair value on your statement of financial condition?  

The real reason for objecting to fair value is captured in the following quote. “Under the stress of current market conditions, accounting policy should focus on measuring the heat of the flame instead of pouring gasoline on the fire.”  In other words, the FASB and the IASB should help bankers hide the results of the risks that they took. 
 
Fortunately, the views of the ABA and IBFED do not have significant support at least as they relate to the choice of using fair value. A review of the “comment letters” available on the Fasb.org web site related to SFAS 159 are quite opposite to those of the ABA and IBFED.  For example, the Canadian Bankers Association in its letter dated April 10, 2006 said, “The Canadian banking industry endorses the FASB’s proposal ….”  Similarly, Countrywide Financial said in their letter also dated April 10, 2006 “We support the Board’s proposal to permit fair value accounting to be applied to financial assets and liabilities on an elective basis.”  Credit Suisse in their letter dated April 10 expressed even stronger support.  Bank of America’s letter dated August 28, 2006 said “We are prepared to adopt the FVO standards as of 1/1/07 if the final standard permits us to do so.”  

An organization calling itself “America’s Community Bankers,” however, said in their letter dated April 7, 2006, “Introducing a Fair Value Option into financial reporting will hinder and confuse efforts at comparing financial statements across entities.”  This could be the case if a fair number of entities do not adopt the provisions of SFAS 159.  I believe   the FASB thinks the superiority of fair value is obvious.  If that is the case, entities that do not adopt fair value will be suspect. 
 
History tells us that in 1802, Thomas Jefferson reportedly said, “I believe that banking institutions are more dangerous to our liberties than standing armies.” Supporting or apposing this view is well beyond the scope of this article. However, it does appear that many large players in the banking industry are willing to report “real financial condition,” rather then trying to hide it.  As my colleague Dr. Paul Miller said in his article titled “Accounting for subprime investments,” one can’t “invest in risky securities but report income from their ventures as if they put money into certificates of deposit.”