The above developments about accounting standards and values are to determine macroeconomic consequences and also regulatory consequences. The real experience was the appraisal of Greek debt at the financial institutions level. There was no doubt that depreciation had to be posted. However, as entrepreneurial liberty allows, depending on their individual views, many of them depreciated the values differently from commercial banks. The regulator had to intervene to impose a general depreciation ratio for banks in the absence of any kind of knowledge about the risk of default, before a governmental agreement was adopted which itself had no more rationale.

The Appraisal Spark Plug that Drives a Continued "Fair Value" Crisis

In our previous book, we described the origin and effect of a “fair value rule” (issued by accounting standard setters) that obliges the accounting profession to assess financial instruments, bonds and equity stock portfolios by comparing their historical posted cost price with their measured value in terms of fair value with the observed difference to be posted in the P&L statement. The “appraisal rule” is general in scope and applies to the entirety of financial instrument portfolios, inclusive of their coverage spectrum and the estimation of volume represented in terms of comparable markets for similar financial instruments. In considering the combined effect of ongoing financial market development (alongside a global slowdown in monetary velocity), it becomes apparent that the accurate determination of fair value is infeasible in the absence of a deeply liquid market, rationally linked to the warrantees attached to the traded instrument when it corresponds to an equity title, when warrantee values for bonds or receivable are unknown or too volatile, or when default rates and interest rates are artificial. Interest rates, especially on long-term collectable instruments, are of key importance and may be influenced by regulation, especially tax and prudential regulation, but also the uncertainties which drive money flows to such instruments. This is, for instance, the case for tax-free and sovereign issuances. The accounting vocabulary has removed the word “market” from its original wording of “fair market value”, but the meaning of “fair” remains questionable due to either the intellectual honesty of standard setters or their understanding of the financial world.[1]

A practical image of the issues can be found by reading the last McKinsey Global Institute (MGI) report of March 2013 on financial globalization (based on 2011 statistics reported to the BIS). In the growth to 325% of financial depth to GDP, it is stated that 25% comes from changes in instrument values. As there is very limited growth in GDPs and very limited inflation, we again see here the disconnection between tangible flows and financials flows, for sure a risk for the financial stability that our system triggers.

This observation raises three issues. The first issue refers to immediate doubts about the soundness of balance sheets in the present financial environment – for example, if portfolios were to be appraised at less than the posted value, then the resulting negative margin would consume outstanding equity, resulting in a destabilized balance sheet profile. A second source of doubt arises when financial markets enter a slowdown phase with contracted liquidity, and the question of “real marketability” for financial instruments arises – including their transaction at sufficient volumes. As we have seen from the euro's past crisis, it immediately raises the question of the capacity of central banks to intervene in the markets to bail them out as the US FED does. A third issue relates to the backing behind financial instruments. If the underlying guarantee value is known to have declined, then the intrinsic value of the instrument is jeopardized. As seen during 2007, in such an eventuality the flow of capital may go into syncope – that is, a marked reduction of transactional turnaround.[2]

In this multifactorial setting, the potential for propagation of financial instrument failures will depend on the degree to which the financial system succumbs to major uncertainty, as opposed to a simple atmosphere of prudence in not relying on short- and mid-term economic forecasts.

Moreover, if even a single but sizable publicly listed company fails or a government is in default, all other entities holding some of its counterparty balances will be affected. This is a historically classic paradigm known to impact banking system entities that cross-hold each other's debt obligations on a range of primary financial instruments, as well as their secondary and tertiary derivatives. Clearly, this was one major reason for the contraction of liquidity affecting money markets during the 2007-2008 crises. One example points to banks who declined to invest in sovereign debt instruments of their own jurisdiction (even when in cash surplus), and who instead preferred to refinance by resorting to central bank mechanisms.

The preceding seems obvious when recalling that one trigger of recent financial market failures involved a deficiency in available cash – needed to satisfy both cash creditors and vendors who are vulnerable to non-payment cascades that generate propagating chains of failure. Surprisingly today, prevailing accounting standards do not directly impose requirements to immediately post any uncertainty of unrealized profits from “market price”-level sales. A second drawback is that by mixing “certain'Vrealized as well as “uncertain'Vunrealized profits and losses on the books, existing accounting procedures tend to obscure the monetary velocity factor, thereby superimposing a major layer of otherwise unrecognized opacity on financial statements. Specifically in this regard, there are many sound reasons for initiating the reform of relevant accounting standards, if not sanctioning the rule setters and authors of such procedures themselves.[3] Certitude should be a universal criterion required in all financial statements. Certitude in payments should be distinguished from value, time and flows that are other appraisal factors to be disclosed separately and analysed depending on the underlying attached guarantees. It is immediately a monetary issue, as facts have shown since 2007, and we have to go into it.

  • [1] It is the limit to their independence that has now been reduced with the presence within their board of representatives of the administration for the FASB, and before with the European process requiring the European Commission to adopt the proposed accounting standards before they became applicable in the EU.
  • [2] Shin, H.-S., Sapra, H., and Plantin, G., “Marking to market: Panacea or Pandora's box?”, Journal of Accounting Research, Princeton University, August 12, 2007, 46: 435-460 (2008).
  • [3] Severinson, C. and Yermo, J., OECD no. 2/12/12. The effect of solvency regulations and accounting standards on long-term investments; implications for insurers and pension funds. This paper calls for extreme prudence with regard to FMV standards.
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