Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Fair value accounting

Earlier this week, the US Securities and Exchange Commission (SEC)
released a 259 page study
on mark to market accounting as required by the TARP related
legislation. The study contains a lot of useful data about the extent
of mark to market accounting in the US financial sector as well as the
extent to which fair value accounting uses opaque valuation methods
(Level 3, often called “mark to myth”).

The key takeaway is that for all the “modernization” of
the financial sector that we read about, mark to market accounting
covers less than half of all assets of the large financial firms. The
percentage of assets where fair value changes impact reported profits
is even lower at 25%. It is only the (erstwhile?) broker dealers who
have practically all their balance sheet in fair value or in short
term assets whose historical cost is practically the same as fair
value. The insurance companies have a large percentage of fair value
assets, but insurance is an industry where the valuation of
liabilities matters more than the valuation of assets. For banks, less
than a third of assets is at fair value.

The percentage of fair value assets which is in Level 3 is not too
bad at around 10%. What I found more troubling is that around
three-quarters of fair value assets are Level 2, leaving only about
15% for Level 1. This is a measure of how little of the financial
sector assets are traded in exchanges or other liquid markets as
opposed to opaque OTC markets. This is another respect in which the
“modernization” of the financial sector has been much more
limited than I would like.

The characterization of financial institutions as storehouses of
illiquid and opaque assets is as true today as it was decades ago.

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