A reminder about new mark-to-market rules in Europe

Recently, there has been a great push in the United States to ease mark-to-market accounting rules. The financial services industry lobby is putting on a full-court press because it believes that easing mark-to-market accounting rules would alleviate some of the pressure on financial institutions to write down impaired assets.

I will not go into the specifics here, but the crux of the lobbyists argument centre on the pro-cyclicality of marking-to-market. Essentially, in good times, asset values are high. Marking them to market gives financial companies a false since of capital strength. However, in bad times when asset prices fall, depressed pricing can lead to phantom capital shortfalls for institutions.

This argument is also one used to dismiss nationalization as an option for banks and to support the Geithner plan. The view here is that recapitalizing banks and buying up bad assets will reduce the pro-cyclical nature of mark-to-market and make it abundantly clear that banks are suffering illiquidity and not insolvency.

That is what is happening in the United States. Danielle, a European reader, recently asked what is going on in the European Union regarding mark-to-market. Basically, the EU has already relaxed mark-to-market requirements as an outgrowth of the market turbulence surrounding Lehman Brothers’ bankruptcy. Below is an October article from Business Week highlighting the key issues.

The European Commission on Wednesday (15 October) changed EU accounting rules to help banks avoid sharp drops in the value of their assets at times of market volatility, such as the present financial crisis.

The move on “mark-to-market” accounting—made by the commission’s accounting regulatory committee—has unanimous support from EU member states and will apply for 2008 third quarter corporate results, due to be published soon.

Under current mark-to-market accounting rules, company assets are valued on the basis of the price they would fetch if they were offered for sale on the market right now instead of what they would be valued were the company to hold on to them until maturation.

During the current crisis, banks in particular have seen their assets plunge in value because of mark-to-market valuation of “sub-prime securities”—financial assets based on loans to borrowers at risk of defaulting—with experts saying the banks’ losses would have been much lower if they were valued on the maturation date basis.

The current practice can create a downward spiral in which companies seem to be insolvent.

But under the commission’s new proposals, banks and other companies can optionally reclassify assets from the “held-for-trading” category to the “held-to-maturity” category, avoiding the trap.

“The current financial crisis justifies the use of reclassification by companies,” the commission said in a statement.

“In these circumstances, financial institutions in the EU would no longer have to reflect market fluctuation in their financial statements for these kinds of assets.”

I am not taking a view on mark-to-market in this post, but presenting the information for your benefit.

Source
EU Eases Mark-to-Market Rules – Business Week
SEC rejects bid to suspend mark-to-market rules – San Francisco Chronicle
Robert Rubin Says Mark-to-Market has Done ‘Damage’ – Bloomberg.com

3 Comments
  1. John Creighton says

    I’m curious as to how they determine the held to maturity value. For instance what do they assume for the: default risk, recovery risk and expected rate or return. If they hold them to maturity they would have to make some kind of assumption about the time value of money. To me it seems as what this does is changes the capital requirements from the current capital value to projected future capital value.

    It doesn’t sound like a bad idea in theory but I think it would make it harder for people to evaluate the finical statements of banks. I wonder what percentage of the capital the banks are allowed to put in this category. To me I’d think the further out the maturity date the less they should be able to count.

  2. Edward Harrison says

    @John,

    Below is a link to a good analysis on mark-to-market versus accrual accounting. The whole process is subject to interpretation, meaning it can be abused. Goldman advocates MTM accounting whereas Citigroup is saying the marks are too low due o pro-cyclicality.

    In my view, this is an issue that will grow in importance as time goes on.

    http://worthwhile.typepad.com/worthwhile_canadian_initi/2009/02/guest-post-mark-to-market.html

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