Fair value accounting

Federal Reserve Bulletin, Wntr, 2005

Adapted from remarks by Susan Schmidt Bies, Member, Board of Governors of the Federal Reserve System, to the International Association of Credit Portfolio Managers General Meeting, November 18, 2004.

Good morning. I appreciate the opportunity to participate in your Fall General Meeting. As my colleagues at the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) will agree, fair value accounting poses many challenges and has sparked significant industry debate.

The subject of fair value accounting has been discussed in the United States for well over a decade. Advocates of fair value accounting believe that fair value is the most relevant measure for financial reporting. Others, however, believe that historical cost provides a more useful measure because it more clearly represents the economics of business performance and because fair value estimates may not be reliable or verifiable.

So, which is more appropriate--fair value or historical cost? Let me share with you the Federal Reserve's long-standing position on this issue. As a supervisor of the U.S. banking system, we want to ensure that financial institutions follow sound accounting policies and practices. We continue to support improved transparency and enhanced financial disclosures, which promote market discipline and provide useful information to decisionmakers. We also support fair value accounting for assets and liabilities used in the business of short-term trading for profit, such as the trading account for banks. And we support enhanced disclosures of fair-value-based information as part of broader descriptions of risk exposures and risk management. However, we believe that the accounting industry should be very careful before moving toward a more comprehensive fair value approach, where all financial assets and liabilities are recorded on the balance sheet at fair value and changes in fair value are recorded in earnings, whether realized or not.

The FASB recently issued a proposed standard on fair value measurements that provides a general framework for valuing assets and liabilities that are currently measured or disclosed at fair value. (1) At this time, it does not expand the use of fair values in the primary financial statements. I would like to summarize and share with you the Federal Reserve's views on the proposed standard, which were provided to FASB in a comment letter as part of the exposure process. (2) We see the proposal as a good first step toward enhancing measurement guidance in this area. However, as I will discuss in a moment, a number of important issues warrant further consideration, especially before dramatic moves are made toward increased fair value accounting.

But before discussing these specific issues, allow me to emphasize one important point. As a bank supervisor, the Federal Reserve believes that innovations in risk management are very important to the continued improvement of our financial system. New methods and financial instruments allow banking organizations to improve their risk-management practices by selecting target levels of risk exposures and shedding or limiting unwanted positions. Accounting frameworks should improve transparency around business decisions and outcomes without providing a disincentive to better management of risk.

FAIR VALUE MEASUREMENT ISSUES THAT WARRANT FURTHER CONSIDERATION

Reliability and Measurement

If markets were liquid and transparent for all assets and liabilities, fair value accounting clearly would be reliable information useful in the decisionmaking process. However, because many assets and liabilities do not have an active market, the inputs and methods for estimating their fair value are more subjective and, therefore, the valuations less reliable.

Research by Federal Reserve staff shows that fair value estimates for bank loans can vary greatly, depending on the valuation inputs and methodology used. For example, observed market rates for corporate bonds and syndicated loans within lower-rated categories have varied by as much as 200 to 500 basis points. Such wide ranges occur even in the case of senior bonds and loans when obligors are matched.

The FASB statement on the proposed fair value standard suggests that reliability can be significantly enhanced if market inputs are used in valuation. However, because management uses significant judgment in selecting market inputs when market prices are not available, reliability will continue to be an issue.

The proposal identifies three levels of estimates, with the lowest priority given to level-3 estimates. These estimates are not based on quoted prices in active markets for either identical or similar assets or liabilities, but rather on mark-to-model estimates. The proposal suggests that the use of multiple approaches, such as the market, income, and replacement-cost methods, will improve reliability of these estimates. However, the number of approaches adds little to reliability if all the methods are based on the same underlying information, as would often be the case for financial instruments.