Under traditional historic cost accounting, bonds that a bank bought for $1m would sit on the balance sheet at $1m until the bank sold them, at which point any profit or loss would be recognised. Under mark-to-market accounting – which became widespread in the 1990s – the value of the bonds is constantly adjusted to reflect the price at which they could currently be bought or sold.
Provided there is a market price to mark to, this kind of accounting is far more useful to investors: it tells them what a bank’s assets are worth today, not what they were worth 10 years ago or what they might be worth in normal economic times. It forces banks to confront problems rather than deny them – and given that uncertainty about which banks have suffered losses is an important reason why they will not lend to each other, covering up losses will not solve the credit crunch, but rather make it worse.
The problem, however, is that mark-to-market accounting is not simply a tool to inform investors. It underlies the balance sheet, and so generates the fundamental number with which a bank is regulated: its capital ratio.
The standard Basel requirement is that a bank’s target ratio of capital to risk-weighted assets should be 8 per cent. Under historic cost accounting, falling market prices had no immediate effect on capital adequacy, but under mark-to-market they create losses, which force banks either to raise more funds or to cut back on lending. There should be a thorough review of the Basel II capital regime, which has other features that make banks cut lending as market prices fall.
Mark-to-market is not perfect. The dozens of assumptions used to value assets with no market price – so-called marking to model – must be thoroughly audited if historic cost accounting is not to be preferable. There may also be the perverse result of banks choosing to hold more illiquid assets in future if they conclude that holding liquid bonds risks mark-to-market losses.
Hiding losses would destroy confidence, not create it, so suspending mark-to-market is not the answer to the credit squeeze. But the capital rules that make mark-to-market a problem cannot be changed overnight and, in the meantime, falling bank capital could create a downward spiral of less lending and further falls in asset prices. The banks either need to raise more capital or they must temporarily be allowed to operate with less.