Financial institutions complained loudly two years ago when the FASB issued a proposed standard on financial instruments that would require fair value reporting for loans with changes in FV being recognized in earnings (FV-NI).  I would describe the bases for these complaints falling into two broad categories.  The first category is the notion that it doesn’t make sense to recognize FV gains and losses on financial instruments that will never be sold.  This argument falls under the “management intent” model of accounting, which is the basis for current GAAP and suggests that the accounting should be based on the business model followed by the company.  Proponents of this model argue that investors are better served when accounting data are viewed from the perspective of the manager.  Critics charge that this model is subject to manipulation by managers and that “management intent” is not an underlying characteristic of the asset and therefore, should not drive its accounting.

The other basis for complaints about FV-NI accounting from bank managers falls in the category of cost/benefit.  Managers of small banks consistently argued that requiring them to mark their loans to market would be imprecise and provide little benefit, while adding another expensive burden to financial institutions that can ill afford it.

Left largely unspoken by bank managers, but surmised by various groups, is that financial institutions did not want FV-NI simply because it would introduce increased risk of regulatory violation due to a significant increase in income volatility.  A new working paper by Hodder and Hopkins (Accounting Slack and Banks’ Response to Proposed Fair Value Accounting for Loans, 2012) provides evidence that supports this view.  The authors find a significant association between the propensity of a bank to write a comment letter opposing the proposed standard and several variables that proxy for the banks’ demand for accounting slack (i.e., the extent of agency problems within the firm).  The authors summarize the implications of their findings as follows:

“Although the comment letters submitted by banks often include justification for current GAAP based on banks’ assertions about their strategy of holding loans until maturity, our reported results suggest that banks writing comment letters have greater agency problems and were more likely to opportunistically use the slack available in current GAAP for loans. This runs counter to the claims of those who oppose fair value accounting based on assertions of its lack of measurement precision and the discretion that managers might use in fair value reporting. Specifically, if firms exhibiting greater opportunistic use of slack under the incurred loss method of accounting are more likely to lobby against fair value accounting for loans, it is unlikely that these firms view fair value accounting as a source of greater accounting slack.”


Prior research has already documented that banks use built-in discretion provided by SFAS 115 to initially classify investment securities in a manner that helps them maintain regulatory capital.  The results from this study suggest that the first broad basis that banks used to justify their opposition to the proposed standard in 2010 might have been disingenuous.  Rather, the evidence suggests that the banks wanted to retain the slack within the accounting system that would facilitate their complying with regulatory requirements.  This reason is not irrational, nor is it sinister.  But, it doesn’t strike me as good justification for standard setters to relinquish their favored position of FV-NI.  (Of course, the second category of cost/benefit is a different matter, and one that I don’t address in this post.)

The authors suggest that the tight inter-relationship between GAAP and regulatory accounting policies might not be a good idea, and that regulators perhaps should be more free to relax some GAAP requirements when establishing regulatory requirements.  However, financial reporting that has the objective of providing quality information to financial statement users should not be driven by a desire to avoid violations of government regulatory requirements.