Banks always played a superior role in business and especially in our today’s internationalised environment their position has become more crucial than ever before. Though, since summer 2007 these financially strong giants have been unhinged by their self-developed ‘financial crisis’ that originated from the US sub-prime market. Due to the instance that the today’s capital markets are interlinked worldwide, it was just a matter of months that the effects of this ‘banking crisis’ unbalanced the entire global economy. Actually large banks became illiquid and the governments had to shore them up, so that the whole financial network did not go to pieces.
Among others, the reason for this disaster was a lack of trust between market participants, caused by enormous amounts of ‘toxic debts’, hidden in the balance sheets of almost every bank that cannot be reliably valued or seem to be worthless. For that reason the professional world and the accounting body IASB came under fire. Especially banks and politicians accused them of having provided inadequate and in-transparent accounting standards, which led to this disaster and amplified the downturn in the world economy. Hence, not only the accounting standard for financial instruments IAS 39 is in the centre of this discussion, especially the IASB's eminently respectable 'fair value' approach has been criticised of being useless in times when markets are absent.
This paper will try finding answers if better accounting standards for financial instruments would have prevented us from this downturn in economy by analysing the origin of the financial crisis and showing the arisen problems. After highlighting its development, the central IFRS standards IAS 39 and the fair value approach will be analysed and evaluated with focus on banks. Finally the IASB’s attempts to manage the arisen problems within the credit crisis will be shown and annotated.
Table of Content
1. Introduction
2. Overview: ‘Financial Crisis’
2.1 'Special purpose entities' and 'mortgage-backed securities'
2.2 Reasons for setting up SPEs and issuing MBSs
2.3 Developing of the sub-prime crisis
3. Accounting for ‘Financial Instruments’ within the financial crisis
3.1 Recent accounting for financial instruments – IAS 39
3.1.1 Categorisation of financial instruments
3.1.2 Fair value and measurement under different market conditions
3.1.3 Overview ‘mark-to-model’ techniques in illiquid markets
3.2 Problems with IAS 39
3.2.1 General problems related to IAS 39
3.2.2 Criticism related to IAS 39 especially during the financial crisis
4. IASB’s response to the problems of IAS 39
4.1 IASB addressing complexity of IAS 39
4.2 Amendment of IAS 39
4.2.1 IASB’s reasons for amending IAS 39
4.2.2 Criticism regarding the amendments of IAS 39
5. Conclusion
Objectives and Research Focus
The research investigates whether existing accounting standards, specifically IAS 39 and the fair value measurement approach, contributed to the economic downturn during the sub-prime crisis and evaluates the appropriateness of these standards for banks in volatile market conditions.
- Origin and development of the sub-prime crisis and the role of 'Special Purpose Entities' (SPEs).
- Mechanisms of 'mark-to-market' versus 'mark-to-model' accounting techniques.
- Evaluation of the IAS 39 standard and its inherent complexity for financial institutions.
- Analysis of political pressure and the resulting 2008 amendments to IAS 39.
- Critical assessment of fair value accounting in illiquid and stressed market environments.
Excerpt from the Book
3.1.2 Fair value and measurement under different market conditions
As one has seen above, fair value measurement is essentially important for initial as well as subsequent measurement regarding MBS and other financial instruments. Fair value is described as “[...] the amount of which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s length transaction” (Deloitte, 2009). There is an implicit assumption that the value provided by public markets is ‘fair’ and that different types of valuation seem to be ‘unfair’ (O’Kelly, 2008). “To meet the objective of fair value measurement, an entity measures the value of financial instruments by considering all relevant market information that is available.” (IASB, 2008c, 7)
IAS 39 prescribes a 5-tier hierarchy, which distinguishes between active markets, where assets are ‘marked-to-market’ and inactive markets, where these ones are ‘marked-to model’. The distinction between active and illiquid markets is not really clear-cut, although it is essential for the choice of valuation technique that has to be applied. Even when there are just low trading volumes, as it was the case concerning MBSs, this market could not be classified as illiquid. (Goldschmidt & Weigel, 2009)
If an active market for the financial instrument exists, the best way for discovering its fair value is looking at the public quoted market price at balance sheet date (1st stage). This one can be provided e.g. from stock exchanges. If there is no available price on balance sheet date (2nd stage), the market price near that date has to be used. At stage one and two securities are ‘marked-to-market’.
Summary of Chapters
1. Introduction: Outlines the impact of the financial crisis on global banking and introduces the critical debate surrounding the IAS 39 accounting standard and the 'fair value' approach.
2. Overview: ‘Financial Crisis’: Examines the origins of the sub-prime crisis, detailing the function of 'Special Purpose Entities' and the securitization process of 'mortgage-backed securities'.
3. Accounting for ‘Financial Instruments’ within the financial crisis: Discusses the framework of IAS 39, the valuation hierarchy in illiquid markets, and the fundamental problems associated with 'mark-to-model' techniques.
4. IASB’s response to the problems of IAS 39: Analyzes the IASB’s attempts to reduce complexity and the subsequent amendments to IAS 39, including the political pressure exerted by the European Commission.
5. Conclusion: Provides a final assessment, arguing that fair value accounting was not the root cause of the crisis and emphasizing the need for IASB independence.
Keywords
Fair Value, IAS 39, Financial Crisis, Sub-prime Market, Mortgage-backed Securities, SPEs, Mark-to-Market, Mark-to-Model, IASB, Accounting Standards, Financial Instruments, Liquidity, Securitisation, Banking, Transparency
Frequently Asked Questions
What is the core focus of this research paper?
The paper examines the role of accounting standards, specifically IAS 39 and the fair value approach, within the context of the 2007 sub-prime financial crisis and their impact on banking stability.
Which accounting standard is identified as the central point of discussion?
IAS 39, entitled 'Financial Instruments: Recognition and Measurement', is the primary standard analyzed regarding its application and subsequent criticism during the credit crunch.
What is the primary research question?
The paper addresses whether the fair value measurement approach is still an appropriate accounting tool in times of market absence or illiquidity.
What research methodology was employed?
The study utilizes a qualitative analysis of accounting literature, standard-setting documents, and reports on the financial crisis to evaluate the effectiveness and criticism of IAS 39.
What are the main topics covered in the book?
The book covers the origin of the sub-prime crisis, the structure of MBS and SPEs, the technicalities of the IAS 39 valuation hierarchy, and the political responses regarding accounting regulation.
Which keywords best describe the work?
The central themes are Fair Value, Financial Crisis, IAS 39, MBS, Securitisation, and banking regulation.
How does the author explain the 'waterfall principle'?
The waterfall principle is described as the mechanism of ranking tranches in MBS according to their credit rating, where cash flows are distributed in a specific order to manage repayment risks for different investors.
Why was the IASB pressured to amend IAS 39?
The IASB faced intense political pressure from the European Commission, which threatened to implement its own legislation if the IASB did not allow for easier reclassification of financial assets.
What is the author's stance on fair value accounting?
The author argues against blaming fair value accounting for the crisis, suggesting that it is merely a reflection of market facts and that blaming the standard is equivalent to 'shooting the messenger'.
What does the 'look-back option' mean in the context of the amendments?
The 'look-back option' allowed entities to retroactively reclassify financial assets as of July 1st, 2008, enabling them to avoid markdowns and potentially 'cherry-pick' assets to improve their financial position.
- Quote paper
- Thorsten Wenke (Author), 2009, Valuation within illiquid markets - Is ‘Fair Value’ measurement still an appropriate approach?, Munich, GRIN Verlag, https://www.hausarbeiten.de/document/137004
