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Accounting through the looking glass

Accounting through the looking glass
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First Published: Sun, May 25 2008. 10 48 PM IST
Updated: Mon, May 26 2008. 02 04 PM IST
Mark-to-market accounting certainly has its flaws. Yet bankers’ recent moans on the method look disingenuous. They happily accepted it when flush times resulted in write-ups. Now, they whinge as asset-price declines cause paper losses.
The Institute of International Finance (IIF), an industry body, proposes to resort to historical prices in times of stress. Goldman Sachs is calling the plan “Alice in Wonderland” accounting. The Wall Street bank is right: IIF’s idea is irrational and bad.
There’s no doubt mark-to-market valuation isn’t perfect, mainly because it’s procyclical. As IIF correctly points out, market valuations become hard to find in illiquid markets. Securities can be difficult to price. And as asset prices fall, investment banks liquidate positions, putting balance sheets under further pressure.
However, this circle spins the other way when asset prices rise. A strong economy raises asset prices. Investment banks holdings in everything from leveraged loans to asset backed securities increase in value. This generates gains on the banks’ income statements.
And since banks aim to have “efficient” balance sheets, the extra capital created by paper profits is redeployed into new investments — causing asset prices to rise and reinforcing the cycle.
IIF wants to value assets at their original price — but only in times of stress. That only addresses half the problem with mark to market — and in a way that is self-serving for IIF’s constituency.
Moreover, especially with the kind of assets and trading mentality common at investment banks, there’s a good case that mark to market paints a more life-like picture of their situations than historical cost would, even if applied on the upside as well as the downside.
The better approach is to change the banks’ underlying behaviour by adopting the central banker’s maxim of “leaning against the wind”.
When the economy is humming, investment banks should store up fat and resist the temptation to put cash to work buying risky assets at inflated prices — cash they only think they have because of bull market paper gains. Then, when the tough times come, the banks could crow over their prudence instead of whining.
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First Published: Sun, May 25 2008. 10 48 PM IST