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Total Number of Subscribers: 467 |
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Date:5th January 2009 |
Compiled by Mr. M. Sathya Kumar |
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Listen IFRS ! - Fair Value
Comes Under Scrutiny Many critics think that the IFRS and US GAAP
have aggravated the global financial situation. The main bone of contention
is the fair value principle that, according to IFRS, is the price at which
they could be sold. During recent periods and due to a variety of reasons there have
been a number of distressed sellers that have caused significant market price
pressures. According to fair value accounting, all such assets must be
revalued to the current market price. Interpretation of this rule has been
responsible for the worst series of bank reporting losses ever witnessed and
has brought the banking system to breaking point. This in turn escalates the
problem by creating more price pressure on those banks that must liquidate.
However, in reality more than 90%1 of these losses are in fact
unrealised, i.e. merely writedowns, and furthermore the assets are continuing
to perform in most cases. Therefore, critics maintain that the requirements
of bank accounting under IFRS appears too positive when an upturn occurs but
too negative in times of crisis. In view of the increasing calls for simplifying or amending the
fair value principle, the question arises if the fair value method should be
given such importance and if it should be applied during distressed periods.
In the recent past there have been other serious crises in the banking
industry that could have resulted in far greater consequential damage. In
such cases, fair value was not in existence, however, and the problems were
managed and overcome - an example being the Latin America crisis. When Does the Market
Value Principle Make Sense?
The market value principle is based on the theory that the
market is efficient and orderly. As the latest developments have shown, however,
the concept of an orderly market can be challenged at present. As an
alternative, experts think it possible to disclose some positions at
historical cost and others at their market value. It is perhaps appropriate
to apply the market value method for short-term, trading stock while it may
be more feasible to account for long-term investments on a different basis.
Problems occur during the absence of clarity and consistency and when models
are used since model calculations are governed by estimates and assumptions
that may result in an inaccurate determination of fair value. Then there is
the risk of veering away from the real market value because each financial
institution uses different parameters for asset valuation. What is the Actual
Significance of the Market Price?
There have always been deficits in liquidity or free float, for
example there is no market price for private placements and banks that hold
few shares for market deals. In such cases, what is the fair value? The case is similar for concentrated positions. If a significant
position (% of the issue) is held, traditionally the market price is applied.
However, it would be impossible to liquidate at this price due to the average
trading amount/lot size, i.e. the position cannot be converted into cash
under normal circumstances. One conclusion is, do we revalue as a going
concern or for liquidation? Other Impacts of Fair
Value
In times of distressed markets, fair value can be seen as
harmful to a bank's liquidity position. Banks' counter balancing capacity for
liquidity risk management relies heavily on securing short-term funding needs
via the repo markets. Consequently, the lower the value of a security the
more difficult it is to raise funds. This can further exacerbate price
pressure due to forced sales etc. Traditional criteria for the pricing of assets
An asset is principally priced according to the following
values:
In an orderly market, each factor is equally considered.
However, in disorderly markets, heavier weighting is given to the last two
factors and thus an imbalance is created albeit only for those who are
interested in trading. Normal Market Versus
Distressed Market
Case study: the Dutch market for mortgage-backed
securities
The property market has shown an unspectacular but sustained
2-3% annual growth for 30 years, during which time securitised mortgage bonds
have been issued. Such securities trade on average at a spread of 65bp over
treasuries. Due to the current and temporary lack of appetite of securitised
bonds, the spread has now increased to 165bp that has nothing to do with the
risk or performance of the covered bond and everything to do with general
current market conditions. It is common knowledge that the Dutch market is
secure, stable and functional and that sub-prime lending does not occur.
However, should banks revalue to the current spread and take an unrealised
loss only to be certain that the spreads will return to what they were for
the past 30 years in 12 to 18 months at the most. Accounting at fair value is
compelling financial institutions to do this. Is this a realistic, accurate
situation? The Next Steps
IFRS rules have been operating for the past five years or so and
during that time the markets have been rather bullish in every sense.
Recently, due to excesses, we are now experiencing a severe correction. IFRS
have not lived through a downturn especially one of such major proportions
and thus it is perfectly reasonable for some cracks to appear. One approach would be to define more clearly what constitutes a
market price and the underlying conditions that must prevail i.e. an orderly
market. Similarly, the rules should state what should be done in a disorderly
market; above all clarity and transparency must prevail. Any action taken to revise fair value should be seen as
evolutionary and not revolutionary, after all, we are now openly taking about
Basel III. Article by Neil Beckley is country manager UK at
FERNBACH-Software, a global provider of software solutions for the finance
industry. He has more than 15 years' experience with triple-A-rated financial
institutions including Deutsche Bank and the Bank of England. |
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