Under fair value, most financial instruments are recorded at their current market price and values are adjusted as markets fluctuate.
As a result of the market turmoil flowing from the subprime crisis, the values of many structured products have plummeted.
That forces many financial institutions into multi-billion-dollar writedowns that have weakened their capital bases and forced them to seek fresh funding.
In a paper written last month and seen by the Financial Times, the Institute of International Finance, which has 300 banks among its members, proposed to relax some of the classifications for financial instruments and to ease the rules in times of financial stress. It claimed that taking prices in illiquid markets “results in valuations that do not provide a true picture of the financial positions of firms”.
This week, it said: “There is a view that [to apply] new techniques, or greater flexibility, in current circumstances would be fraught with difficulties.”
The Financial Times’ reporting of the original paper last week prompted Goldman Sachs to threaten to leave the IIF, calling the proposals “Alice in Wonderland” accounting.
There is growing recognition by regulators that the introduction of fair value accounting on a wide scale has changed the dynamics of how the financial system responds to crises.
“This has been a big structural change,” says a senior regulator.
But while some recognise potential disadvantages, they stress there have also been benefits and there is reluctance to endorse suggestions that the change should rapidly be reversed.
Malcolm Knight, head of the BIS, says: “In my opinion, while fair value accounting can lead to over-depreciating assets in distressed market conditions, it has the advantage of focusing everyone’s mind on the impact of the deleveraging process on asset values.”