FASB Chairman Defends Fair Value, Calls for Separation From Banking Regulation

FASB Chairman Robert Herz on Tuesday delivered a rapid-fire policy speech that addressed head-on criticism of the role of accounting standards in the financial crisis and called for GAAP to be “decoupled” from bank regulation.

Herz, speaking at an AICPA conference, contended that many of FASB’s critics simply do not understand its mission. “There seems to be some confusion in the media and elsewhere about the relationship between the accounting standards we set and regulation of financial institutions,” said Herz. He explained that FASB does not determine the capital levels banks are required to maintain, but under laws enacted in the wake of the savings and loan crisis, bank regulators determine regulatory capital caccstarting with GAAP numbers. But bank regulators can adjust the GAAP figures, and they also have other tools to address capital adequacy, liquidity issues, and concentrations of risk at regulated institutions, Herz said.

He said that while FASB has a deep interest in the strength and stability of the financial system and the economy, its public policy mission and focus is designed to be different from that of banking regulators. “Our focus as accounting standard setters is on the communication of relevant, reliable, transparent, timely, and unbiased financial information on corporate performance and financial condition to investors and the capital markets,” he said.“The transparency provided by external financial reports contributes to financial stability by reducing the level of uncertainty in the system—and a lack of transparency can hide the extent of risks facing financial institutions from both investors and regulators.”

The mandate of the Federal Reserve and other banking regulators, according to Herz, differs in that it relates to ensuring the soundness of banks and the overall stability of the financial system.He says most of the time FASB and banking regulators can find common ground, but in some situations they’re actually in conflict. “In dire situations, bank regulators may be appropriately concerned that public release of data on severe losses and asset impairments could spark a run on a bank,” said Herz.“But investors would likely want to know the extent of the problems on a timely basis.”

The answer to this problem, according to Herz, is to “decouple” bank regulation from U.S. GAAP reporting requirements. “Doing so could enhance the ability of both the FASB and the regulators to fulfill our critical mandates,” he said.

And Herz, citing a 1991 GAO report following the S&L crisis, seemed to indicate that he believes that although GAAP and specifically much-criticized fair-value accounting did not cause the financial crisis, a GAAP unencumbered by pressure from banking interests would have done a better job of alerting investors and other stakeholders of an impending crisis. “The [1991] GAO report found that regulatory call reports significantly overstated the values of loans and debt securities (and hence the financial condition and capital) of failed banks,” he said.

He pointed out that the stress tests banking regulators recently conducted of the 19 major U.S. bank holding companies also found that the bulk of the $600 billion of potential additional losses revealed under the more adverse scenario related to loans and other receivables carried on a historical cost basis such as that used in the 1980s and not to items carried on a mark-to-market or fair value basis. In other words, fair value accounting, which is currently applied to only some financial assets, has done a better job of indicating the true financial condition of those assets than the cost basis.

Addressing another criticism of fair-value accounting, Herz admitted that reporting fair values can have procyclical effects on behavior. But he contends that “timely recognition of problems at financial institutions can have countercyclical effects through lessening the impact of financial downturns by providing an early warning of developing problems.”

This year both FASB and the IASB, under pressure from political influences, have struggled to agree on changes to accounting for financial instruments, which involves the fair value applications that have been most widely criticized. Herz provided assurances that FASB and the IASB would continue to work together on these issues, while acknowledging that the two boards have recently had differences in approach and timing. “Next year, once we have received comments and other input on our proposal, we will redeliberate at public board meetings all the key issues identified including discussing them with the IASB and making changes as appropriate,” he said. “Only after having completed this very extensive and thorough public due process will we issue a final standard carefully considering effective dates and transition.”

On Monday, the AICPA’s Accounting Standards Executive Committee (AcSEC) issued a comment letter to FASB in which the committee indicated that it favors an approach that would measure “many but not all” financial instruments at fair value. The AcSEC letter cited a 30-year fixed rate mortgage loan held to maturity as an example of a financial instrument that should not be measured and recorded on the balance sheet at fair value.

—Matthew G. Lamoreaux (mlamoreaux@aicpa.org) is a JofA senior editor.