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In: Finance

With shareholders and lenders (i.e. investors in bonds issued by a bank) in mind, what are...

With shareholders and lenders (i.e. investors in bonds issued by a bank) in mind, what are potential explanations for the fair value option requiring the seemingly counter intuitive accounting treatment for fluctuations in fair values of financial liabilities.

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Expert Solution

Banks’ accounting has never been more newsworthy. That is reflected in a new report by KPMG which combs through the annual reports of 16 European banks to identify trends in the sector. The report is worth reading for anyone interested in banks, although cautious auditor KPMG stops short of stating opinions about the quality of those reports. That leaves me space to draw on the report to outline an opinion of my own: the problems with banks fair-valuing their own debt. According to KPMG, HSBC reported a €2bn ($3bn) gain from fair-valuing its own debt last year. Next of the banks to be surveyed – at some €800m – was Barclays. Fair-valuing your own debt, when its value falls, not only leaves it on the balance sheet, but also results in a gain that feeds through net income. This is a recurring theme in the debate about fair value. Only last week, Merrill’s second quarter earnings noted a $98m gain from a weakening in its own credit standing (although that is small beer compared with a pre-tax loss of $8.2bn for the division in which the gain was included). This month, Lehman Brothers filed its second quarter 10-Q which showed a $400m gain from fair-valuing its own liabilities. I do not want to suggest banks are doing anything amiss in fair-valuing their own liabilities. In many cases, the choice was made long before the credit crunch and it was done because the instrument was linked to a hedge or a derivative trade. The basic problem is that most people find the whole notion counter-intuitive. It is as if I were to suggest to my credit card provider that because I’m in some financial difficulty they should lower the amount I owe in order to reflect the fact I’m less likely to pay it. For companies, the thinking goes that they can now buy the debt back at the lower price. But this rarely happens in practice. Falling debt value generally implies a company in trouble, meaning it would struggle to find the cash. As far as my credit card provider is concerned, it might lower the amount on its books that it expects to get from me if I were in trouble, but it’s not going to tell me to pay less back. On my personal books, I still owe the full amount. So while the market (or my credit card company) has marked down the debt’s value because it appears there is less chance of recouping the whole, that doesn’t mean the borrower actually owes any less. In general, fair value provides more objective numbers for investors to analyse and that is a good thing. But in the case of debt, it runs the risk of masking true liabilities and flattering profits. The theoreticians warn that failing to fair-value both the financial assets and the liabilities would make the balance sheet uneven. True. But there are ways to get around that. The importance of a market-based fair-value opinion of an asset’s worth is in a different class to market value for a liability the company is still obliged to pay in full, and the accounting ought to reflect that. In theory, fair-valuing own debt sounds good. In practice, the cheap, early buy-back won’t happen. What does happen instead is accounts become even less intelligible to those with anything less than “expert” status.


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