Volcker and Greenspan: Mark to Market

 

Paul Volcker on Mark to Market Accounting 

Former Fed Chairman, Paul Volcker, Chairman of the Group of Thirty, Consultative Group on International Economic and Monetary Affairs, Inc., just released a study with recommendations on financial reform.

Recommendation #12 on Fair Value Accounting reads as follows:

“a. Fair value accounting principles and standards should be reevaluated with a view to developing more realistic guidelines for dealing with less liquid instruments and distressed markets.

b. The tension between the business purpose served by regulated financial institutions that intermediate credit and liquidity risk and the interests of investors and creditors should be resolved by development of principles-based standards that better reflect the business models of these institutions . . . .”  

Alan Greenspan on Mark to Market Accounting

On November 1, 1990, Federal Reserve Chairman, Alan Greenspan, in a 4-page letter to Richard Breeden, Chairman of the Securities and Exchange Commission, said, in part:

“The Board believes that market value accounting raises a substantial number of significant issues that need to be resolved before considering the implementation of such an approach in whole or in part for banking organizations.

Accounting methodology should be developed to measure the results of a particular business purpose or strategy; it is not an end in itself. For an institution whose business purpose is to trade marketable financial assets on an intra-day basis, for example, closing daily market values would measure the success or failure of that particular business purpose. An end of the day balance sheet, marked to market, is clearly the appropriate accounting procedure in the example.

Generally, the business strategy of commercial banks, on the other hand, is to employ their credit insights on specific borrowers to acquire a diversified portfolio of essentially illiquid assets held to term. The success or failure of such a strategy is not measured by evaluation such loans on the basis of a price that indicates value in the context of immediate delivery. Clearly, one aspect of value in an exchange is the period of delivery.  But the appropriate price for most bank loans and off-balance sheet commitments-is the original acquisition price adjusted for the expectation of performance at maturity. It is only when that price differs from the book value of the asset that an adjustment is appropriate.

A reserve for loan losses is such an adjustment. To mark such an asset to a market price intended to reflect the value of a loan were it liquidated immediately is interesting, but not a relevant measure of the success of commercial banking.”

A blurry copy of Chairman Greenspan’s letter is provided here.

Comments (9)

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  1. cc says:

    time for you, greenspan, and every other MtM opponent to form a private equity firm and buy up stakes in US banks.

    policy prescriptions are one thing, putting $ where your mouth is another.

    if you passionately believe this issue is hampering the underlying value of these firms, and these loans in and of themselves, you should seriously consider raising a vulture fund or throwing in with someone like Hilltop (gerald ford).

  2. Alan H says:

    Thanks for the great commentary on this subject, Mr. McTeer. With Volcker on board, I have some hope now that a realistic change can be implemented.

  3. JustOne says:

    I wonder where the “religious-fundamentalist” adherence to mark-to-market “faith” is based. Are markets “god given” an inalienable right to price all things?

    The world is full of examples of market variability and mispricing of assets. For example, there are whole schools of technical analysis focused on taking advantage of market errors in pricing of assets and risks.

    PBS has a huge hit show that continuously exposes market errors when a toy or picture or other item is bought for a few dollars at an estate sale but in the “right” auction would be worth 10s of thousands of dollars (in the opinion of the expert appraisers).

    Why does the FASB put so much faith in markets? Markets are manipulated, markets are often closed, markets are subject to group psychology and dynamics, markets are anything but a consistent measure of value. They are constantly “correcting” their errors. If markets are the PRIMARY source of truth in our banks’ asset values, no wonder they are having trouble maintaining liquidity and reserve ratios.

    In the words of a famous reporter … “Give me a break.”

  4. JKH says:

    The problem with MTM accounting is that most people view it as a necessary condition for transparency (in the usual financial sense of that word).

    It isn’t. It is sufficient, but not necessary.

    The necessary condition for transparency is MTM disclosure.

    The necessary and sufficient condition for transparency is MTM disclosure without MTM accounting.

    Disclosure is different than accounting. Accounting affects capital. Disclosure doesn’t necessarily affect capital. Disclosure without MTM allows the matching of time horizons between the life of assets and their effect on capital. And it allows shareholders to make an independent judgement on the effect of MTM disclosure on the market value of equity. In this sense, MTM accounting forces a double-up valuation of MTM in both the book value and market value of equity. This redundancy is absolutely dysfunctional.

    As to exactly what the best complementary accounting to MTM disclosure might be, I don’t know precisely.

    But the more critical point is to understand at the outset that MTM accounting is not necessary for transparency, and that it is accordingly suboptimal for accounting and capital measurement.

    I think this logical imbroglio may be why there is such a division of opinion between two groups of thinking on the issue, both of which include intelligent and experienced people.

  5. KC Kid says:

    Sometimes an analogy helps.——————– If you were to “Mark to Market-ize” (M2M-ize) the cruise control on your car you would need to reverse the action it now takes when your car slows down or speeds up. ——– As the car slows down instead of pushing the accelerator pedal down to speed the car back up, as a normal cruise control would do, the M2M-ized version would instead let up on the pedal. ——— Thus the car would slow down even more causing the M2M-ized cruise control to lift the pedal up even more. ——— This cycle would be repeated until the engine eventually was at idle and the car stopped moving or was moving at minimum speed (assuming a flat road). Of course the reverse is also true. ——— So when this type of seeming logical yet improper feedback is introduced into the banking system it tends to help produce (destabilizing) boom and bust cycles. Of course if you are an active trader that’s great but if you are a retired long-term investor it’s pretty scary. ——— If M2M is to be kept, which I’m not in favor of, we need to find some way to help stabilize the system. ——- That’s why the counterintuitive recommendation from some of inverting the capital raise requirements makes sense from a dynamic system analyst’s perspective. —— Right now anything that causes capital raise requirements, which M2M does in a down economy, will tend to cause banks to let up on the lending pedal. —— That in turn reduces the velocity of money and economic activity (MV=PQ) thereby causing more defaults driving the market marks down even further. And, the cycle repeats itself until the economy comes to a standstill or is finally reversed with gigantic sums of new money. This process is particularly troubling because the banking system is naturally leveraged which amplifies the effect.

  6. [...] on the inappropriateness of mark to market accounting for the commercial bank business model [click here]. I also quoted from a recent report issued by Paul Volcker on the same [...]

  7. [...] the SEC was contemplating bringing it back in the early 1990s, the head of the Federal Reserve (Alan Greenspan), the head of the FDIC (William Taylor), and the Secretary of the Treasury (Nicholas Brady) all [...]

  8. [...] I’ve written about before, Alan Greenspan argued passionately about the inadvisability of applying mark to market to commercial banks whose [...]

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