A new study, whose coauthors include a faculty member at Stanford’s Graduate School of Business, addresses the question that has been a subject of almost theological debate among accountants for decades. But the financial crisis of 2008 and 2009 elevated it to a pitched political battle between the banking industry and financial reformers.
During the financial crisis, when debt markets became frozen by panic, banks were caught with billions of dollars in securities that could only be sold for pennies on the dollar. Bank critics and many investors argued that many banks were effectively insolvent, and were hiding their problems by refusing to write down their holdings to “fair” or current-market value.
The banking industry fought back ferociously, arguing that current market values were irrelevant because banks hold many of their securities all the way to maturity. As long as a security was still paying as it should, they argued, the only thing that really mattered was its historical cost.
In 2010, the Financial Accounting Standards Board (FASB), which sets accounting rules for the United States, jumped into the fray. At the time (and still), U.S. Generally Accepted Accounting Principles (GAAP) required some financial instruments to be carried at fair value but allowed many others to be recorded at their adjusted historical cost.
The FASB’s 2010 proposal was for institutions to value almost all of their financial instruments at fair value. Banks and their allies howled in protest. The FASB received 2,800 comments, most of them bitterly opposed to its proposal. Sympathetic members of Congress warned that the FASB would cripple the banking system and the economy. The FASB retreated somewhat, but it is still working on its proposals, and the fights still simmer.
But which approach comes closest to the truth? The new study tries to answer that by analyzing the predictive power of fair-value calculations that banks are required to include as footnotes to their official financial statements.
Their firm conclusion: Contrary to claims by the banking industry, the fair-value calculations provide a far more accurate indicator of a bank’s risk of failure than the bank’s official calculations based largely on historical cost.
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Previously on abfjournal.com: