As the ministry of finance evaluates a proposal to create a Financial Stability and Development Authority, as India Inc. prepares to adopt the IFRS, and as G-20 puts more focus on financial reform, one issue straddles these three events. This issue relates to the effect of financial accounting practices on financial stability. In particular, does mark-to-market accounting accentuate financial crises vis-?-vis the traditional practice of accounting at historical cost? More generally, given the significant impact that accounting standards can have on financial markets and the macro economy, can accounting standards be left solely to the accountants?
The market value of an asset or liability is more relevant than its historical cost because the market value reflects the price at which that asset could be bought or sold in a current transaction between willing parties. In fact, in light of the several accounting scandals in recent times, good corporate governance and mark-to-market accounting represent two sides of the same coin. Sunlight is supposed to be the best disinfectant! Similarly, mark-to-market accounting can light up the dark corners of a firm?s accounts. Since market prices reflect all the consequences of a firm?s actions, market-to-market accounting can be beneficial in precluding the dubious practices of corporate managers. Yet, requiring mark-to-market accounting for financial assets or liabilities, in general, and financial firms, in particular, is fraught with perils and needs careful consideration.
To comprehend relevant issues, consider an example outside the world of finance and accounting. The Millennium Bridge in London, which is a bridge built for pedestrians, uses an innovative lateral suspension design; it does not contain the tall supporting columns that characterise other suspension bridges. On the day it opened for use, the bridge began to shake violently within moments of the bridge?s opening; pedestrians fearing for their dear lives clung on to the side-rails. This violent swaying of the Millennium Bridge offers important clues to the way financial markets operate. The principle of diversification?which is one of the bedrocks of finance?suggests that having many people on the bridge offers the best way of cancelling out the sideways movements on the bridge. However, what is crucial to understanding financial markets is the way humans react to their environment. Pedestrians on the bridge react to how the bridge is moving. When the bridge moves from under your feet, each person adjusts his or her stance to regain balance.
The catch here is that everyone adjusts his or her stance at the same time. This synchronised movement makes the bridge move even more. A greater movement of the bridge, in turn, forces people to adjust their stance more drastically setting off a spiraling effect where the wobble of the bridge feeds on itself through the coordinated actions of the pedestrians. So, the violent swaying continues and gets stronger even though the initial shock?a small gust of wind?has long passed.
Financial markets mirror this phenomenon. As with the bridge?s movements, financial prices play a dual and symbiotic role?not only do they reflect underlying economic fundamentals but are also imperative to action. Mark-to-market accounting ensures that any price change shows up immediately on the balance sheet. So, when prices change, banks adjust their stance more than they used to, and marking to market ensures that they all do so at the same time. Such coordinated actions feed into themselves to generate a downward spiral of rising volatility.
When the incentives offered to market participants lead them to behave myopically, i.e. pursue actions that generate value in the short run but destroy value in the long run, mark-to-market accounting can have a pernicious effect on financial stability. Absence of liquidity only adds to this deadly mix since in illiquid markets, prices reflect panic substantially more than underlying economic fundamentals.
Despite such overarching impact of accounting practices on financial markets and the macro economy, accounting standard setters?domestic ones as well as the International Accounting Standards Board?view their remit as being restricted to ensuring that accounting values reflect current terms of trade between willing parties. However, as witnessed in the recent financial crisis, accounting standards have far-reaching consequences for the working of financial markets and for the amplification of financial cycles. The constituency that is affected by accounting standard changes is far wider than the ones the standard setters have in mind. This raises an obvious question: Isn?t accounting too important to be left solely to the accountants?
Existing research resoundingly answers ?yes? to this question. Accounting has all the attributes of an area of public policy, intimately linked to financial regulation and the conduct of macroeconomic policy. As such, accounting rules must be a crucial component in the overall public policy response to the financial crisis. To account for the intricate issues that are involved, the IFRS standard setting exercise needs the expertise of financial economists apart from that of accountants.
?The author is an assistant professor of finance at Emory University, Atlanta, and a visiting scholar at the Indian School of Business, Hyderabad