Of Accountants and Dead Parrots

Holding forth on the causes of last years financial crisis has lately become something of a cottage industry. Developments in economics and finance are usual suspects as are incentive structures that encourage excessive and even foolish risk-taking. Without doubt there is some truth in all of these claims.

Last Thursday, Floyd Norris reminded us of a much more pedestrian cause: changes to accounting standards that allowed financial institutions to appear healthier than they really were and that allowed them to take positions that they otherwise would not have been able to. As Norris tells it

The accountants let us down.

That is one of the clear lessons of the financial crisis that drove the world into a deep recession. We now know the major banks were hiding dubious assets off their balance sheets and stretching rules if not breaking them. We know that their capital was woefully inadequate for the risks they were taking.

Efforts are now being made to improve the rules, with some success. But banks have persuaded politicians on both sides of the Atlantic that the real problem came not when their financial inadequacies were obscured by bad accounting, but when they were revealed as the losses mounted.

“There were important aspects of our entire financial system that were operating like a Wild West show, huge unregulated opaque markets,” said the man whose job was to write the accounting rules, Robert H. Herz, the chairman of the Financial Accounting Standards Board.

“The crisis highlighted how important better transparency around that system is,” Mr. Herz added in an interview this week. “I would hope that would be a major lesson learned or relearned.”

Unfortunately, some seem to have learned exactly the opposite lesson. Accounting rule makers at FASB and its international equivalent, the International Accounting Standards Board, have been lambasted for efforts to improve transparency by forcing banks to disclose what their dodgy assets are actually worth, as opposed to what the banks think they should be worth.

Both boards have tried to resist, but have been forced by political pressure to back down on some specifics. In the case of FASB, the retreat took a few weeks after Mr. Herz was ordered to act at an extraordinary Congressional hearing. The international board was given a long weekend to retreat, with the European Commission threatening to impose its own rules if the board did not cave in. Both boards tried to reduce the damage by forcing more disclosures, but it is unclear how much good that will do. Neither was willing to defy the politicians.

As so many have argued for so long, changes to fair value accounting methods largely concealed the condition of the financial sector. As Norris notes

The banks have argued that market values can be misleading, and that their own estimates of the eventual cash flow from assets are more realistic than what they — or others — will now pay for those assets. The rules already allowed them to ignore so called “distress sales” in assessing fair value, but the banks pushed to broaden that exemption in the United States, while in Europe they got the regulators to allow them to retroactively stop calculating market value for assets they said they did not intend to sell.

Behind the scenes, there is a battle pitting securities regulators — who instinctively favor disclosure — against banking regulators, who fear there are times when disclosure could make a bad situation worse.

The securities regulators argue that accounting should do its best to report the actual financial condition of a company. If the banking regulators want to allow banks to use different rules in calculating capital — rules that would not require marking down assets, for example — then they can do so without depriving investors of important information.

But that information could scare those investors, and set off the kind of panic that brought down Lehman Brothers a year ago.

It is the job of banking regulators to keep their institutions healthy, and that effort can only be helped by accounting that reveals problems early. But if the banks do get into trouble, some regulators would prefer to maintain the appearance of prosperity while efforts are made to fix the problems quietly.

The brings to mind the Monty Python classic about the dead parrot



As with the parrot, no amount of subterfuge will permanently disguise the facts.