FSA chief opens debate on accounting for banks

Fair value/mark to market accounting promotes dramatic rises and falls in financial markets, and clashes with the needs of regulators, the long awaited Turner Report on regulating the banks has concluded.

The report, produced by Adair Turner, chairman of the Financial Services Authority, calls for a debate between regulators and international accounting standard setters, plus their counterparts in the US, to find a way forward.

But the FSA said it wanted a 'counter-cyclical approach' to bank capital to be reflected in highly visible published accounts 'creating strong shareholder and management awareness of the need to assess profitability in the light of the position in the economic cycle.'

The report said:'mark-to-market accounting helped fuel a self-reinforcing cycle of irrational exuberance.'

It added: 'While it is difficult to quantify the effect,it is a reasonable judgement that the application of fair value/mark-to-market accounting in trading books, played a significant role in driving the unsustainable upswing in credit security values in the years running up to 2007,and has exacerbated the downswing.'

The report said mark to market/fair value accounting benefits shareholders and particular institutions. It even went so far to say that those banks who used it to recognise their losses as soon as possible during the banking crisis emerged in better shape.

But it said the principle of fair value was not necessarily the greatest aid to regulators.

Among a swathe of recommendations the FSA said it favoured the introduction of an Ôeconomic cycle reserveÕ to be put aside for when revenues fell. This would be shown on the balance sheet.

But the FSA said there were arguments to place it on the profit and loss account so that bottom line profits and earnings per share could be calculated before and after the apllication of a reserve.

Incentive based pay could then be worked out after the reserve had been taken into account.

The FSA has left the specifics of any accounting changes to be worked out at a later date.

The FSAÕs remarks could strenghten the argument of those who have demanded a suspension of markt to market accounting.

However, there was an initial welcome. Steve Priddy, technical director at the ACCA said: 'It is essential that published accounts help contribute to financial stability. Lord Turner’s analysis of the challenge posed by the need for accounts, which are both meaningful at an individual level and at a macro level, appears to be sound. His proposal for an Economic Cycle Reserve is both interesting and worthy of debate.'

Michael Izza, chief executive of the ICAEW, questioned whether published accounts should calculate profits after taking intoto account an economic cycle reserve: He said: 'It is very difficult to predict our position in the economic cycle. This proposal could potentially undermine transparency of financial reports.'

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