To FASB or not to FASB?

HEARD the joke about a businessman who asks his accountant what two plus two is? The accountant draws the blinds, leans over the desk and whispers: “What would you like it to be?” The crafting of accounting rules is more art than science, thanks to the need to balance the interests of companies, their investors and—especially in banking—their regulators. No great surprise, then, that the world’s two big standard-setting bodies—America’s Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB), which covers most other countries—are on very different tracks in their treatment of financial instruments.

Investors are still digesting the 214 pages of proposals released by FASB on May 26th. But if adopted, these would shake up banking by greatly expanding the impact of fair-value (or mark-to-market) accounting, in which assets are valued at market prices rather than on an historic-cost basis that reflects the price banks paid for them.

In both America and Europe, instruments held for sale are marked to market, whereas loans intended to be kept on the books are held at cost. Although fair-value adjustments for the latter are already disclosed in banks’ accounts, FASB now wants them to be reflected in income. By contrast, IASB, which unveiled its own proposals last November, wants to spare loans held to maturity by banks from the vagaries of the market. The two also differ on how banks should reserve for deteriorating credit, with FASB again putting forward the more radical proposals.

Though FASB’s board was split, passing its proposals by three votes to two, opponents portray it as a bastion of mark-to-market zealotry. Fair value, fine for capital markets, is inappropriate for bog-standard banking, say industry groups. Banks want to avoid a repeat of the recent crisis, when fair-value losses forced a scramble for equity in dislocated markets. They warn darkly of bigger swings in bank earnings and capital, complicating efforts by governments and regulators to dampen “procyclical” forces, and of a lack of long-term credit as banks shy away from the loans likely to have the most volatile values.

The counter-argument is that higher volatility reflects market reality. It is there whether you measure it or not, so why brush it under the carpet? The problems of Spain’s savings banks suggest that pain can be delayed but not avoided. In a survey by the CFA Institute last November, 52% of investors supported fair-value accounting for all loans. Robert Herz, FASB’s chairman, has argued that by presenting loans under both approaches, it is bridging a divide, not veering to extremes.

The effect on some banks would be dramatic (see table). But the median American bank values its loans at only slightly below fair value, so the overall impact would be modest. And there could be benefits on the liability side of the ledger: under FASB’s proposals, the three largest American banks could write up the value of their core deposits by anywhere between $38 billion and three times that, says Mike Mayo of CLSA, a brokerage.

It is hard to see how FASB and IASB will reconcile their differences. FASB could soften its stance during the four-month comment period, but it can hardly have been unaware of outsiders’ arguments when it drew up its proposals. It may be forced to bend by politicians—who mostly dislike the brutal honesty of fair value—just as it did last year when criticised over its stance on toxic securities. European politicians applied intense pressure to IASB when it was drawing up its proposals.

If the two cannot meet in the middle, remaining differences could probably be dealt with through disclosure. Each would essentially require banks to show how their holdings would be treated under the other method, though only their own would affect income. Although supervisors can adjust accounting standards to assess regulatory capital, such divergence sits awkwardly with hopes for a global capital standard. Some experts, including Mr Herz, support decoupling accounting standards from bank regulation so that bank assets are presented in two formats to meet investors’ desire for transparency and regulators’ craving for stability. Either way the current mess is a joke.