The Impact of Crisis on the Determinants of Leverage

4 Victoria Krivogorsky reference to the actual performance of loans. In this regard, fair value accounting, they believe, undermines the banking system by wiping out capital from the books that in turn starts a chain of negative events. Specifi cally, it increases the odds of asset fi re sales that make markets even less liquid; bad loans multiply, the investment banks fail, and the government proposes bailouts. The latter drives prices down even further, fueling violent downward economic spiral. 4 As a result, the “mark-tomarket accounting rules have turned a large problem into a humongous one. A vast majority of mortgages, corporate bonds, and structured debts are still performing. But because the market is frozen, the prices of these assets have fallen below their true value.” 5 Persuaded by such arguments, some politicians in the US and Europe have called for the suspension of fair value accounting in favor of historical cost accounting, according to which assets are generally valued at original cost or purchase price. 6 Mark-to-market accounting continues to have its supporters, who are equally unwavering. Among others, there has been an opinion suggesting that accounting simply delivers the news to the market. Professor Lisa Koonce from the University of Texas wrote in Texas magazine:

This is simply a case of blaming the messenger. Fair value accounting is not the cause of the current crisis. Rather, it communicated the effects of such bad decisions as granting subprime loans and writing credit default swaps. The alternative, keeping those loans on the books at their original amounts, is akin to ignoring reality .

Following the same line of logic, the Financial Accounting Standards Board (FASB) investment advisory committee asserted that fair value approach is all the more necessary in today’s environment, and that “it is especially critical that fair value information be available to capital providers and other users of fi nancial statements in periods of market turmoil accompanied by liquidity crunches.” In this view, if banks did not mark their bonds to market, investors would be very uncertain about asset values and therefore reluctant to help recapitalize troubled institutions. 7

Another accounting regulation blamed for the fi nancial crisis is the accounting for derivatives. It was publicly stated in literature and press that derivative fi nancial instruments had rendered the current approach to banking regulation obsolete. 8 For example, let’s assume that a fi nancial institution holds only one “investment.” It is an interest rate swap, with a notional amount of $50 billion. The historical cost of entering into the swap was zero, and its current fair value is $1 billion. Also, assume that the bank has liabilities of $0.5 billion. With a debt/asset ratio of 50%, this bank can be technically considered as well capitalized? However, in a case when interest rates move insignifi cantly in the wrong direction, a $1 billion asset could transform into a $10 billion liability. Moreover, the probability of that occurring could be 50% or more .