Fair value limited.
Contingent preference formation in international accounting standard setting 1
Daniel Mügge
Universiteit van Amsterdam, The Netherlands
d.k.muegge@uva.nl
Bart Stellinga 2
Scientific Council for Government Policy (WRR) , The Netherlands
stellinga@wrr.nl
Abstract
Recent scholarship on international financial regulation has disaggregated state preferences and
concentrated on preference formation among key actors, in particular regulators. Deducing
preferences from standard economics understandings of financial market functioning, this work
assumes that regulators face a trade-off between enhancing the competitiveness of domestic firms
(laxer standards) and enhancing stability (tighter standards). While sensible for example in banking
regulatory, this approach is at odds with the empirical record in international accounting standard
setting: here, regulators’ positions have been highly volatile and inconsistent over time.
As we argue in this paper, this finding does not invalidate the aim of using economic theory
to deduce preference formation. Heterodox economic theorizing, drawing on Keynes and Minsky,
suggests that tighter (that is, less flexible) accounting standards can be both a bane and a boon for
financial stability, depending on overall market conditions. The pattern we find in 15 years of
international accounting standard setting dovetails with this intuition: regulators’ specific policy
preferences are contingent on their assessment of market conditions at the time, leading them to heed
banks’ calls for a more flexible accounting regime at one point, only to tighten the reigns shortly
thereafter – always in the name of financial stability.
This paper shows how economic theories that have gained currency in the wake of the
recent financial crisis can be made fruitful for IPE theorizing. They allow us to model how a stable
policy goal – financial stability – can lead to diverging policy preferences over time and hence portray
regulatory politics in accounting standard setting much more realistically.
The authors extend their thanks to the organizers of the AGORA workshop in Brisbane in January
2011 for their hospitality and its participants for the valuable comments. We are also grateful for the
feedback we received at the SGIR conference in Stockholm in September 2010, at the International
Political Economy and Comparative Stratification club at the University of Amsterdam in November
2010, and at the COST-ESRN conference in Bielefeld in December 2010.
2 The views expressed in this paper are solely those of the authors and should in no way be associated
with the WRR.
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1
INTRODUCTION
Since the 1980s, cross-border standardization and international regulatory regimes
have become key features of global financial governance. 3 Many scholars recognize
the importance of this trend, but they disagree on the motivation of key actors to
endorse particular regulatory arrangements rather than others. What drives global
regulatory politics: the interests of financial firms, concerns about financial stability,
ideational dynamics, the inter-state distribution of power, or yet something else? 4
Although constructivist work has nuanced our understanding of how actors arrive at
their particular preferences, most scholarship in the field assumes that we can
identify sources of these preferences that rest outside of regulatory cooperation
itself. 5 If preferences are at least partially prior to such cooperation, understanding
their sources better is a central task for students of global financial governance. As
Jeffrey Frieden has argued for the study of politics in general, actor preferences can
simply be assumed, inferred from observations (‘revealed preferences’) or – most
usefully for modeling – deduced from theories covering preference formation itself. 6
More recently, David Lake has specified this view, claiming that the deduction of
interests from economic theory is the defining innovation of open economy politics
(OEP), the dominant approach in contemporary International Political Economy. 7
For global financial governance, David Singer’s work has been particularly helpful for
theorizing national preferences, articulated by regulatory agencies, in international
cooperation. 8 In line with what is implicit in much other scholarship, Singer models
the international politics of banking regulation as a compromise between two
opposing policy goals: enhancing the competitiveness of national financial industries,
which argues in favor of laxer standards, and financial stability, which requires more
On the general trend, see Braithwaite and Drahos, 2000, Mattli and Woods, 2009, Drezner, 2007,
Büthe and Mattli, 2011. Early finance-specific work includes Kapstein, 1992, Cerny, 1993, Porter,
1993, Helleiner, 1994. More recent book-length contributions are Underhill, Blom, and Mügge, 2010,
Germain, 2010. With Daniel Drezner (2007: 11), global governance is understood here as ‘the
collection of authority relationships designated to monitor, enforce, and amend any transnational set
of rules and regulations’. Note that authority relationships can be both formal and informal.
4 Kapstein, 1992, Oatley and Nabors, 1998, Singer, 2007, Posner, 2009, Simmons, 2001.
5 Woll, 2008, Widmaier, 2010.
6 Frieden, 1999.
7 Lake, 2006.
8 Singer, 2004, Singer, 2007.
3
2
stringent standards. 9 These motives rhyme with mainstream economic theory: capital
reserves constitute a cost for banks, and those with lower costs have a competitive
edge. 10 At the same time, the bigger capital buffers are, the more likely it is that banks
can withstand a deterioration of their loan portfolio or overall asset devaluation. 11
Regulators’ policy preferences are a function of this trade-off: they evade potentially
deleterious regulatory competition by seeking international rule harmonization,
which allows sustaining regulatory stringency required to safeguard financial
stability. 12
As we show in this paper, even though the stability-competitiveness trade-off is
crucial in explaining preference formation and hence governance arrangements in
banking regulation, it is less helpful in other domains, including accounting standards
– the case discussed in this paper in detail. Here, the policy preferences of regulators
do not spring from an unchanging trade-off between stability and competitiveness.
Instead, the relationship between stability and competitiveness itself changes over
time. Depending on market circumstances and regulators’ expectations of the future,
laxer rules can be both a boon and a bane for financial stability. Lax rules can
facilitate the build-up of systemic risk, but they can also provide banks with crucial
breathing space in times of distress. Whether regulators see lax or stringent rules as
the route to market stability thus depends on collective assumptions about future
market developments.
While this emphasis on expectations and historical contingency sits uneasily with
mainstream economic theory, it chimes in well with many heterodox economists’
understanding of financial market functioning. The credit crisis that started in 2007
has reignited interest in the work of John Maynard Keynes, Hyman Minsky and
9 The trade-off between financial stability and pandering to financial industry interests pervades the
political economy literature on financial regulation. See e.g. Underhill, 1995, Underhill, 1997.
10 Mainstream economic theory is understood here as neoclassical economics, in which actors are
presumed to have unambiguous preferences.
11 The real-world solution to this tension are US-led cross-border agreements on minimum capital
requirements. Oatley and Nabors, 1998, Simmons, 2001, Singer, 2004.
12 Building on the early work of Tiebout (1956) on regulatory competition (cf. Esty and Geradin,
2001), such behavior has been usefully theorized as co-opetition (McCahery and Geradin, 2004),
which fuses regulatory competition and cooperation. On regulatory competition in international
financial services regulation, cf. Jackson and Pan, 2001, Trachtman, 2001.
3
Benoit Mandelbrot. 13 They all emphasize that financial markets have no natural
anchor (the equilibrium point in neoclassical economics), but that they are driven by
market participants’ expectations. Soros has helpfully labeled this feature
‘reflexivity’. 14 As we argue, where mainstream economics is unable to account for
regulators’ stances towards accounting standard setting, heterodox economics that
heeds market reflexivity succeeds. It makes comprehensible the seemingly
contradictory stances that regulators take over times and their varying levels of
support for financial industry positions. In this way, our argument meets the recent
call by Helleiner and Pagliari for ‘more cyclical theories of private influence [on
financial rules]’. 15 Contingency and market expectations, which themselves are
cyclical in nature, are key to our argument.
Empirically, this paper concentrates on the rise of fair-value accounting (FVA) as the
most important trend in world-wide accounting over the past decades. 16 The project
of weaving FVA into every thread of accounting has been pursued by the
International Accounting Standards Board (IASB) in particular. The Financial
Accounting Standards Board (FASB), responsible for setting US standards, has put
similar emphasis on FVA. However, given that the FASB is firmly embedded in
domestic American politics while the IASB has assumed a quasi-global role, the latter
lends itself much better to an analysis of international regulatory politics than the
former. 17
13 Key works are Keynes, 1964 [1936], Minsky, 2008 [1986]; Mandelbrot’s thinking on finance is
summarized in Mandelbrot and Hudson, 2004. For other recent applications, see e.g. the special issue
of the International Journal of Political Economy entitled ‘Keynes, Minsky, and Analyses of the Financial
Crisis’ (2010) and Mirowski, 2010.
14 Soros, 1998, Soros, 2008.
15 Helleiner and Pagliari, 2011: 180.
16 Fair value accounting shows assets and liabilities at their current market value on the balance sheet
rather than at historical cost, that is, at acquisition cost (André et al 2009: 4). The fair value of an
instrument is generally defined as ‘the amount for which an asset could be exchanged, or a liability
settled, between knowledgeable, willing parties in an arm’s length transaction’. The practice of fair
valuing assets and liabilities involves periodic revaluations of these instruments with reference to
shifting market prices.
17 Donnelly, 2007. On the relationship between the IASB and FASB in the politics of international
standards setting, see e.g. Posner, 2009, Leblond, 2011 forthcoming. As we argue below, mutatis
mutandis the argument about preference formation among financial regulators advanced here equally
applies to the US domestic politics of accounting standard setting.
4
The IASB efforts to promote FVA ran into political trouble in the late 1990s, again
in the early 2000s and yet again one year into the credit crisis. Each time, conflict was
ignited by disagreements over the application of FVA to financial instruments – the
linchpin for struggles over FVA in general. Even though the standard covering these
instruments is only one among several dozen, convoluted political fights about
accounting for financial instruments turned into the moment of truth for the FVAproject as a whole. As we demonstrate in this paper, plugging heterodox economic
theory into our understanding of the politics of accounting standards explains both
the positions regulators have taken at particular moments and the dynamics of these
fights over time. Ever since the IASB published a provisional standard in the late
1990s, accounting standard setting for financial instruments has been in limbo, with
one temporary fix following the other. International agreement on how financial
instruments should be treated in firms’ is as remote now as it was when the IASB
started its work. Infusing heterodox economics into IPE accounts of international
regulatory politics explains why.
In this way, the contribution of this paper goes beyond the political economy of
accounting standard setting. It shows how what Lake has called the key strength of
the OEP-approach – the use of economic theory to model actor preferences – need
not be restricted to neoclassical economics. In finance and financial regulation in
particular, OEP can be combined with theories of financial markets which, in
contrast to their neoclassical brethren, have been vindicated by the global financial
crisis. In this sense, we see our case as an important, and hitherto rare, illustration of
how disparate traditions in political economy can be fruitfully combined. 18
This paper proceeds as follows: it first shows how scholarship on international
financial governance has failed to address fully how the specific content of financial
rules may matter to the governance dynamics surrounding them. After surveying
political economy treatments of international accounting standard setting, we outline
the theoretical basis of our argument, showing what a heterodox understanding of
financial market functioning implies both for policy preferences meant to serve the
competitiveness of financial firms and, in particular, financial stability.
18
Cf. Phillips and Weaver, 2011.
5
The empirical section treats the key episodes of political contestation over the work
of the IASB since it has risen to prominence in the mid-1990s to show how our
argument explains the otherwise puzzling stances regulators have taken. The first
episode of conflict revolves around the Joint Working Group of Standard Setters,
which between 1997 and 2001 unsuccessfully promoted full fair value accounting for
banks. Then, between 2002 and 2005, the IASB and EU authorities were at
loggerheads over the International Accounting Standard (IAS) 39, again intended to
impose FVA on banks. And finally, between 2008 and 2009, standard setters and EU
authorities once more clashed over the way forward with FVA under crisis
conditions.
THE POLITICAL ECONOMY OF FINANCIAL REGULATION
We see the preferences of policymakers who are directly involved in financial
regulation as important data to understand better the development of financial
market rules. In this sense, our argument stands in the tradition of scholarship that
traces the evolution of such rules instead of using large-n data sets to determine the
causal drivers behind rule changes. 19 As we will demonstrate below, the focus on
preferences formation is particularly relevant because in the case we study these
preferences are highly contingent on external conditions, which significantly
complicates modeling them for the purpose of quantitative analysis.
Earlier qualitative comparative work in financial governance concentrated on
variation in between-country and over time variation in financial sector profiles,
national economic institutions and the reactions of both public and private actors to
increasing economic openness or technological change. 20 These scholars addressed a
common question: what has been the key driver behind financial deregulation or
market-oriented re-regulation? The thick descriptions of policy processes contained
in this scholarship obliterated the need for elaborate theories that explained actors’
professed preferences. Instead, the observations of these preferences could be used
directly, with over-time changes in actors’ preferences, political resources and
The field of large-n studies is enormous. Prominent international comparative work includes Quinn,
1997, Abiad and Mody, 2003; key across-state comparison concentrating on the USA is Kroszner and
Strahan, 1999. On the differing approaches, see Gerring, 2007: 37ff.
20 Pauly, 1988, Moran, 1991, Sobel, 1994, Coleman, 1996, Vogel, 1996, Josselin, 1997, Laurence, 2001.
19
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institutions as aggregators of preferences accounting for policy changes. Policy
preferences themselves warranted no problematization as financial firms, investors,
regulators and finance ministries – the key actors in most accounts – faced no
obstacles in identifying their overarching goals and tying these to specific policy
preferences.
Post-1970s financial deregulation spawned enormous growth in private sector crossborder financial transactions, and hence incentives to coordinate regulation
internationally. This coordination became a second, related focus of scholarly
attention. Kapstein emphasized the epistemic dynamics in the 1988 Basel
negotiations, but much consecutive work concentrated on the distributive
dimensions of international regulatory agreements. 21 Attempts in the European
Union to forge a single market for financial services were analyzed in a similar vein,
with emphases on competitive concerns of national financial industries or the latters’
embeddedness in national ‘varieties of capitalism’, as they later became to be called,
as sources of national preferences. 22 The political constellation thus fit Moravcsik’s
liberal intergovernmentalism in which alternative depictions of domestic policy
processes could be inserted into bargaining models. 23
More recent scholarship has refined our understanding of both the international and
domestic bargaining processes. On the international level, the dependent variable of
most studies has been the international harmonization or otherwise of financial
standards. They have commonly pointed to two drivers of such harmonization. As
discussed above, agreement on common rules across an integrated market with
fragmented jurisdiction (nation states in a globalized economy) can prevent
regulatory races to the bottom, which might be inimical to other policy goals. 24 More
specifically, international harmonization may be desirable when unilateral imposition
of preferred rules on domestic markets creates significant negative externalities. As
Simmons as argued, the presence or absence of such externalities has been key to
explaining whether the USA has cared about other countries’ adoption of US
Kapstein, 1992, Oatley and Nabors, 1998.
Story and Walter, 1997, Underhill, 1997, Underhill, 1997.
23 Moravcsik, 1997, drawing in this respect on Putnam, 1988. For a more recent application of great
power diplomacy to regulatory politics, see Drezner, 2007.
24 Vogel, 1995, Esty and Geradin, 2001.
21
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standards, and if so, whether it has found it necessary to impose them through
international agreements rather than being able to rely on voluntary third-party
adoption. 25
The second common driver is the boost to effective cross-border market integration
that results from standard harmonization. As Mattli and Büthe argue, the politics of
such harmonization combine distributive and welfare-enhancing logics. 26 Still, both
globally and within the European Union, where cross-border standard harmonization
has progressed farthest, the easing of international transactions remains a key
incentive to agree common rules. 27
Which standards emerge victorious from such international coordination? For
financial rules, Simmons convincingly argued that US regulatory preferences have
long been a natural center of gravity because of the exorbitant size of US capital
markets. 28 By denying market access to countries unwilling to follow the regulatory
lead of the USA, it could effectively set international standards if it so desired. The
unification of financial markets in the European Union and the relative resurgence of
London as a financial center have allowed the EU to challenge US leadership at least
in some regulatory domains. 29 If the relative distribution of power thus explains
whose rules prevail, their substance depends on the adjustment costs that new rules
impose on the parties to the regulatory agreement. With adjustment costs lowest
when the status quo is maintained, international regulatory politics effectively
becomes a tug-of-war between the attempts of powerful jurisdictions to universalize
their domestic standards. Substance is not theorized per se, but measured relative to
prevailing national rules. 30
One way in which substance itself has entered contemporary theorizing of
international financial regulation is through the relative stringency or laxity of rules. 31
Simmons, 2001, cf. Egan, 2001.
Mattli and Büthe, 2003.
27 Egan, 2001.
28 Simmons, 2001.
29 Posner, 2009.
30 The relative measure in this case are the costs arising from a switchover to alternative regimes.
31 Notably Singer, 2004, Singer, 2007. In his model of international regulatory politics, Drezner also
‘normalizes’ disparate regulatory measures into a ‘unidimensional measure of regulatory stringency’.
Drezner, 2007: 52.
25
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In the international politics of banking regulation, the key variable is the level of
capital reserves that banks have to keep as a buffer against losses. Keeping such
capital reserves constitutes a cost for banks as it constrains their lending capacity.
Hence, relatively lower capital reserve requirements constitute a competitive
advantage. At the same time, bank losses on their asset portfolio tend to accumulate
in economic downturns, meaning that periodically banks’ capital base needs to
withstand particular stress. Higher buffers make banks themselves more resilient and
increase the mutual trust of counterparties in distressed capital markets. Beyond the
focus on relative stringency, the specific content of financial rules has mostly
remained outside the purview of IPE scholarship on international financial
governance.
This omission was justified in light of assumed homogeneity of actors’ preferences
regardless of their provenance. Banks around the world would see their competitive
position boosted by relatively low capital reserve requirements, just as such low
requirements would endanger financial stability in Japan as much as in Germany. Put
differently, a focus on regulatory content appeared to hold little inferential valueadded for understanding better patterns of international governance. Private and
public objectives were neatly aligned with unambiguous policy preferences – an
assumption that does not hold at all for accounting standards, as we will show below.
Regardless of how actors’ preferences are formed, whose preferences matter in
international financial governance? And hence, on which actors should we focus our
analysis? As a quick survey of the literature directly suggests, the answers vary widely
between different issue-areas. 32 Some policy domains are governed by international
organizations such as the International Monetary Fund (IMF) that act as agents of
national governments. Depending on the presumed level of IMF autonomy, the
appropriate actors to study are national governments as principals or (policymakers
within) the Fund itself. 33 The emergence of the Basel Accord and its successors is
mostly analyzed as a mix of intergovernmental politics, national or transnationally
For recent overviews, see Porter, 2005, Germain, 2010.
See the chapters by Broz and Hawes, Martin, and Gould in Hawkins, Lake, Nielson, and Tierney,
2006. The principals still reign supreme for example for Drezner, 2007, while many others have
emphasized the importance of preference formation at and within the IMF itself. Barnett and
Finnemore, 2004: 45ff., Woods, 2006, Chwieroth, 2009.
32
33
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organized financial industry interests, and cognitive dynamics within the Basel
Committee itself.
34
Depending on the specific perspective taken, national
governments, central bankers assembled in the G10, national lobbying associations
or transnational advocacy bodies such as the Institute of International Finance or the
Group of Thirty move into view. 35 Transgovernmental regulatory networks can
facilitate both the diffusion of ideas and specific standards with government coercion
or formal agreement. 36 Credit ratings agencies have themselves been analyzed as a
form of standard setters. 37 Accounting standard setting, discussed in more detail
below, has been studied both as a contest between the European Union and the USA
and as a prime example of private authority in international affairs. 38
What emerges from this wide array of actors at the center of analyses is that which
actors should be studied depends both on the case at hand and the question to be
answered. In many domains the authority is dispersed over a variety of levels or links
in a chain of delegation. Without any hard claims about the ultimate source of
authority in any given domain, we pragmatically argue that the most useful locus for
analysis is that in which the relevant variation originates – whether that concerns
industry preferences or belief systems that change over time or national preferences
that vary across countries. In line with Singer’s approach to banking regulation, this
consideration underpins our focus on bank regulators as the actors who have to
marry the dual public policy objectives of financial stability and bank
competitiveness, and who, through the balance they strike between the two, have
important influence on the eventual rule outcome.
THE ESTABLISHED VIEW ON RISE OF FVA
Much recent political science scholarship on the international politics of accounting
standards has concentrated on the competition between public actors in influencing
the direction of global standard setting. 39 In this view, transatlantic rivalry stands
central in the politics of international accounting and the success of FVA, certainly in
Kapstein, 1992, Oatley and Nabors, 1998, Wood, 2005, Tarullo, 2008.
Tsingou, 2003.
36 Bach and Newman, 2010: 505, Baker, 2010.
37 Sinclair, 2005, Lake, 2010: 604ff.
38 Perry and Nölke, 2005, Mattli and Büthe, 2005, Posner, 2009, Büthe and Mattli, 2011: 40ff.
39 Mattli and Büthe, 2005, Posner, 2009, Büthe and Mattli, 2011, Leblond, 2011 forthcoming.
34
35
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Europe, is seen as epiphenomenal to the rise of International Financial Reporting
Standards, the successors to IAS, as produced by the IASB. 40 These approaches treat
global accounting standard harmonization itself as a trend that is sustained by
increasing cross-border financial integration, irrespective of the specific content of
the standards that are being promulgated. For example, Chua and Taylor attribute the
prominence of IFRS to the legitimacy of the IASB as a standard setting body, which
happens to champion FVA. 41
While this work is helpful for understanding the trend towards international and
global harmonization of standards, it has less to say about the content of these
standards, particularly because standard setting has been outsourced to private bodies
(the IASB and the FASB) while the political fights unfold between their public
sponsors (the EU and the USA, respectively). Hence, what FVA does to or means
for the economy at large is mostly ignored. Standard setting is effectively seen as a
coordination game, making accounting rules not much different than, say, the
BlueRay format as the successor of the DVD, over which a hard struggle has been
fought against the HD DVD. 42
Scholarship that hones in on the rise of FVA itself points to a conflict between
different stakeholders in accounting systems, most importantly preparers and users,
and the way in which their political leverage and interests have changed over the past
decades. Different approaches to accounting serve different purposes and hence
different stakeholders. 43 With the rise of shareholder value as a guiding concept in
corporate strategy since the 1980s, investors have allegedly become eager to assess
the opportunity costs incurred by leaving a corporation whole instead of selling its
constituent parts. 44 If the net present value of projected future cash flow is less than
the market value of a company’s net assets, leaving it intact equates incurring a loss.
More generally, the growth of financial securitization has lessened the utility of
accounting techniques that fail to keep track of the market values of the assets and
Dewing and Russell, 2004.
Chua and Taylor, 2008.
42 For international standard setting as a coordination problem, see Snidal, 1985, Abbott and Snidal,
2001, Mattli and Büthe, 2003.
43 Rayman, 2006.
44 Lazonick and O'Sullivan, 2000, Froud, Johal, Leaver, and Williams, 2006.
40
41
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liabilities into which a company could be broken up. 45 In the mainstream view on
accounting that underlies these arguments,
organizations are sets of implicit and explicit contracts [..].
These parties have different preferences [..], which gives rise
to conflicts of interests and thus to contracting and
monitoring problems. Accounting information can address
these problems. 46
Barth et al. have demonstrated that outside users of accounting information prefer
FVA over historical cost accounting (HCA) in the presentation of corporations’
economic results. 47
The critical pendant to this view sees the rise of fair value accounting as evidence of
a growing dominance of financial channels of accumulation over profits directly
derived from industrial production (financialization as understood for example by
Krippner). 48 Arnold formulates it as a question:
Does the domination of finance over industrial capital
explain the move towards fair value accounting and the
abandonment of the income measurement model in favor of
a balance sheet valuation approach to financial accounting? 49
The work of Perry and Nölke suggests such a conclusion. 50 According to Nölke,
FVA is essential for financialization. 51 As financial assets have become more
profitable than production assets in recent decades, investors support FVA so that
shifting balance sheet values are recognized and recorded as profits.
In spite of other theoretical differences, both the mainstream view on the rise of
FVA and its critical version agree that with the introduction of FVA, accounting
rules are amended at the behest of the users of accounts – whether conceptualized as
investors or (financial) capitalists. While these actors’ preferences are plausible, it
remains unclear how they translate them into tangible policy change. Big accounting
firms, the financial industry, large multinational non-financials and a select group of
Barlev and Haddad, 2003.
Leuz, Pfaff, and Hopwood, 2004: xxv.
47 Barth, Beaver, and Landsman, 2001.
48 Krippner, 2005.
49 Arnold, 2009: 806.
50 Perry and Nölke, 2006, Perry, 2009.
51 Nölke, 2009.
45
46
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public actors populate the relevant policy communities.
52
In contrast, the
constituency the aforementioned approaches put central is hardly visible in policy
debates and formalized deliberation. More importantly, even when the role of
interest groups such as banks and insurance companies is taken into account, actors’
interests are largely taken as given and static unless disturbed by exogenous shocks.
How can this view be squared with the frequently shifting positions of both public
and private actors over accounting rules?
THE CONTINGENCY OF VALUATIONS AND THE POLITICS OF ACCOUNTING
We argue that the politics of accounting standard setting cannot be understood
without acknowledging the inherent limitations of accounting, in particular for
financial assets. These limits of different accounting methods, and the practical
ramifications of their implementation, are what leads public stakeholders to shift
their policy preferences over time and give the concomitant arguments for one or the
other methodology different weights. Large banks may at one moment favour
particular aspects of FVA, only to reject them later, just as public authorities oscillate
between calls for rigorous application of FVA on the one hand and watered down
rules that allow banks to withstand losses on the other.
The contingency of value
Most accounting scholars recognize that things do not have one quantifiable value,
which could, given proper measurement instruments, be identified objectively.
Hence, so the argument of the proponents of FVA, the current market value of any
asset or liability is the best value estimate we have given that – if a market for that
asset or liability indeed exists – this valuation integrates the independent assessments
of a wide variety of observers. That is what makes the value ‘fair’, even if it is not
‘correct’ or fundamentally fixed. Standards setters have consistently taken this view.
As for example Keynes and Minsky have pointed out and as the credit crisis has
demonstrated forcefully, market valuation of assets, and financial assets and
derivatives in particular, can be extremely volatile. 53 Current assessments feed market
52
53
Perry and Nölke, 2005.
Keynes, 1964 [1936], Minsky, 2008 [1986]. Cf. Mandelbrot and Hudson, 2004.
13
behaviour and can generate (temporarily) self-fulfilling prophecies, herd behaviour,
etc. 54
Neither of the two valuation methods that has traditionally been available has good
answers to this problem. Historic cost accounting fails to update banks’ books to
reflect their current market position. Traditionally, this has mostly been a problem on
the asset-side of the balance sheet. An economic downturn may mean that banks are
unlikely to recover the money they have lent out. Bad debts start amassing that let
creditors doubt the ultimate viability of banks, thereby stifle lending to businesses
and foster the build-up of risk in the financial system that remain hidden not only
from the view of other market participants, but also financial supervisors.
The rise of derivatives has exacerbated this problem. Many derivatives, even simple
products such as options and futures, entail contingent liabilities, in which the
amounts owed vary in line with market conditions. Given that the original cost of
issuing the derivative can be a fraction of the ultimate liability incurred, they augment
the potential for banks’ real assets and liabilities to diverge widely from their reported
positions. Historic cost accounting clearly is a poor guide to a bank’s affairs.
FVA generates its own problems. On a micro-level it can be argued that fair value
accounting relies on the existence of deep and liquid markets in order to establish
reliable values. For many financial instruments, such markets do not always exist.
Banks and supervisors have to rely on models or estimates to gauge values,
introducing a highly subjective dimension into accounting and causing uncertainty as
to the reliability of the estimated value. On a macro-level, FVA can introduce more
pro-cyclicality in the financial system. Dropping market prices may trigger sales on
particular instruments, further depressing their value, triggering more sales, etc. This
is especially acute when FVA involves recognizing changing values directly into the
profit and loss account.
Bank competitiveness and contingent policy preferences
What do these shortcomings of accounting standards mean for bank
competitiveness? In line with arguments about the relationship between bank
competitiveness and capital reserve requirements, those rules are understood as
54
Akerlof and Shiller, 2009.
14
increasing competitiveness that, ceteris paribus, boost banks’ profits. For accounting
standards, this remains a relevant concern as European banks, covered by IASB
rules, compete with American firms, which throughout the period studied here have
been required to use FASB standards.
As a consequence of this asset values’ contingency, bank incentives to favor either
FVA or HCA at any given moment depend on other factors. Ceteris paribus, banks
can be expected to favor FVA in times of market upswing, as it allows them to
record rising asset values as profits. Also, as market participants, banks have an
interest in understanding the market positions of their counterparties. At the same
time, rigorous FVA application has clear downsides. Most obviously, in market
downswings, as during the credit crisis, financial institutions may be forced to markto-market the falling values of assets which they may not even want to sell and the
cash-flow position of which remains solid. 55
Furthermore, if FVA is applied to the whole balance sheet of a bank, including its
liabilities, counterintuitive situations arise: a bank in trouble, which would see its own
traded debt fall in market value, would be allowed to record its own liabilities at a
discount and, in an extreme scenario, post a profit as a consequence. Real liabilities
would be understated. Applying FVA only to assets also creates problems, as the
matching between assets and liabilities that defines the banks’ risk management
becomes undone, particularly with respect to untradeable assets such as loans, which
banks intend to hold until maturity. Finally, only valuing tradable assets at FVA also
is no viable option. Banks and insurance companies regularly use derivatives to hedge
risks in their portfolios. What may make sense from a risk-management perspective
would be invalidated, however, if the hedged instruments were treated differently
than the hedge itself. In short, there exists no consistent, let alone universally agreed,
valuation technique that is appropriate for financial institutions.
As the empirical analysis below will show, banks have as a consequence called for
divergent accounting treatments throughout the economic cycle. Their ultimate
preference, however, has been an accounting regime that gives them discretion in
This argument was particularly common with respect to senior-tranches of collateralized debt
obligations, which were downgraded and hence revalued during the crisis even though the underlying
payments were still coming in.
55
15
classifying assets in line with both their function in the portfolio (for example
hedging) and market conditions. That flexibility can be used both to dampen the
impact of market fluctuations on banks’ balance sheets and to hide losses until it is
too late to correct them.
Financial stability and contingent policy preferences
Public authorities deal with a similar set of problems. International Financial
Reporting Standards are in the first instance designed by the IASB. To become
effective for example in the European Union, they have to be endorsed by the EU’s
Accounting and Regulatory Committee (ARC), which brings together member state
representatives. 56 In most instances, the ARC endorses IASB standards without any
changes. As outlined below, standards concerning financial instruments have been
the key exception. By modifying standards on its own or simply refusing
endorsement, the ARC has exercised its power in defiance of the IASB’s putative
private authority. ARC committee members have followed the line set out by
banking regulators and supervisors, who are responsible for safeguarding financial
stability. 57 This makes regulators, charged with spelling out policy preferences in light
of overall policy goals (financial stability without competitive disadvantages for
domestic firms), the key actors both for modeling and the empirical analysis set out
below. How does the contingency of assets’ market valuations translate into policy
positions?
To the degree that accurate information about market participants’ financial position
is indispensable for financial market functioning, public authorities have strong
incentives to support FVA. 58 At the same time, in the name of financial stability, they
have big stakes in the viability of banks and other financial institutions as going
Dewing and Russell, 2004.
Regulatory and supervisory responsibilities are carved up in different ways around the world. The
Basel Committee for Banking Supervision has a misleading title, as it is involved in regulation (setting
standards) rather than only supervision (monitoring their implementation). To avoid cumbersome
language, and because rule setting is the key activity that counts here, this paper will henceforth use
the label ‘regulators’ for those entities that are either directly involved in or de facto shape the design
of the relevant financial rules. This may include regulators proper, but also central bankers or financial
ministry officials. For the purpose of our analysis, they share the contingent preferences that let them
argue in favor of flexibility at one point, only to call for more stringency the next.
58 On the ambiguous role of transparency in international financial and monetary governance, see
Best, 2005.
56
57
16
concerns. 59 Regulators cannot afford to endorse standards that can endanger
financial stability by pushing key financial institutions over the brink. Hence, in times
of distress, they have incentives to adopt the banks’ view: desirable standards are
those that forestall pernicious losses, regardless of whether they are consistent. The
link between financial stability and the viability of banks has important consequences
for the relationship between regulators and the financial industry. The former have a
strong incentive to support the latter in order to serve their own policy goals –
stability. Regulators who visibly cared about the well-being of their own firms are
often accused of having fallen prey to regulatory capture. 60 While we acknowledge
the disproportional influence firms, and financial firms in particular, can exercise
over public policy, regulators do have incentives to argue the banks’ case which goes
beyond such capture. 61
Regulators have to advocate discretion for banks, which is inimical to their original
preference for transparency and rigorous application of a single set of standards to
aid market functioning. With respect to policy preferences (bank discretion versus
rigorous application of one set of standards), regulators thus have two hearts beating
in their breast: as guardians of banks’ proper conduct, they cherish bank openness
about their financial positions. As guardians of banks’ survival, they may dread that
same transparency (see table 1).
The contingency of valuations that we put central in this paper implies that there is
no escape from this problem, except perhaps by a radical overhaul of the financial
system. 62 Even if a pure FVA regime were the point of departure, endemic bouts of
market euphoria and the ensuing downturns would endanger financial stability and
hence spawn calls for more flexible accounting rules. In this sense, the problems
59 Banking regulators may also fear that FVA push banks away from their traditional activities (borrow
short and lend long), especially when fair value accounting is applied to bank loans. The fair value of
bank loans is calculated as the net present value of these loans, which depends on current interest
rates. Small fluctuations in these interest rates can cause great shifts in the value of the loans, especially
when the loan is long term. Banks dislike such exposure to income fluctuations, and may turn their
attention away from long term assets or shorten the average maturity of a loan.
60 Stigler, 1971.
61 A good example of such capture is Kroszner and Strahan, 1999. For the influence of financial firms
on regulation in general, cf. Sobel, 1994, Underhill, 1995, Mügge, 2010.
62 An example of a drastic proposal that may effectively address the problem at the heart of
accounting standards is forbidding banks to incur debt (including customer deposits), turning them
into mutual funds instead. Kotlikoff, 2010.
17
dogging accounting standard setting are similar to those that keep financial crises
from recurring irrespective of efforts to prevent them. 63 Without objective measures
to determine whether assets are over- or undervalued, it is impossible to know
whether another boom or bust is in the offing. This paper demonstrates how this
logic plays out in real-world accounting standard setting.
Table 1: Overview of policy goals, preferences, and accounting regimes
Standard setters
Financial firms
Regulators
Policy goal
Market efficiency
through
transparency
Competitiveness (boosting
profits)
Financial stability
Policy
preference
Consistent:
rigorous
application of
single set of
standards
Consistent: discretion in
application of FVA or
HCA
Contingent: rigorous application of
standards in benign market
conditions, required flexibility for
banks in times of market distress
Preferred
accounting
regime
Consistent: FVA
Contingent upon market
conditions FVA in market
upswing, HCA in
downswing
Contingent upon market
conditions: FVA in market
upswing, FVA or HCA (depending
on bank-specific circumstances) in
times of market distress
ACCOUNTING POLITICS BEYOND REGULATORY CAPTURE
The main conflicts over FVA as proposed by the IASB fall into three episodes,
recounted below. These episodes show that what drove conflicts, and what kept
them going, was not a clash between stakeholders with clear preferences for one or
the other accounting system. It was precisely the ambiguity on this point that time
and again let stakeholders revisit extant policy arrangements. At times, regulators
sided with the financial industry out of a concern for the viability of banks in
particular. But it would be wrong to mistake such alliances for regulatory capture.
Where banks’ preferences could be detached from their own stability and survival,
regulators had no qualms rejecting them.
Episode I: The Full Fair Value proposal (1997-2001)
The International Accounting Standards Committee (IASC, the predecessor of the
IASB) started working on the development of an adequate standard for financial
instruments in the 1990s. Its project gained momentum in 1995 when the
63
Kindleberger, 1978, Minsky, 2008 [1986], Reinhart and Rogoff, 2009, Akerlof and Shiller, 2009.
18
International Organization of Securities Commissions (IOSCO) announced that its
official recognition of International Accounting Standards (IAS) as of 1998 was
conditional on the existence of such a standard. 64 The IASC realized that reaching
consensus on such a standard would be difficult, so it opted for a two-step approach.
The first step was to issue IAS 39 in 1998 as an interim standard in order to meet the
IOSCO deadline. This standard was heavily modeled on the US Statement of
Financial Accounting Standard (SFAS) 133. Simultaneously, the Joint Working
Group of Standard Setters (JWGSS) was set up, in which national accounting experts
were to develop a standard that would be more suitable for the long term than IAS
39 was. 65 The principle that would, in the opinion of the IASC, preferably underlie
such a standard was put forward in a 1997 IASC Discussion Paper, which held that
all financial instruments be measured at fair value (full fair value accounting, or
FFVA).
In the draft standard the JWGSS issued in 2000, it indeed proposed abandoning IAS
39 in favor of a FFVA model. The JWGSS argued that fair value was the most
relevant measurement attribute for financial instruments and that generally
sufficiently reliable estimates of their fair value would be obtainable. 66 This model
would provide a richer basis for the analysis of financial statements and would
facilitate its predictive as well as its stewardship purposes. 67 This was deemed to be
the case because ‘[f]air value reflects the market’s assessment of the effects on
financial instruments of current economic conditions, and changes in fair value
reflect the effects of changes in those economic conditions when they take place’. 68
Changes in the fair value of financial instruments should immediately be recognized
Walton, 2004: 13. International Accounting Standards were issued by the IASC. The IASB (the
successor) inherited the old standards (IAS) but itself only issues standards called International
Financial Reporting Standards (IFRS), which eventually should replace all IAS.
65 The JWGSS, in which the IASC participated, comprised accounting representatives from 13
countries (the USA, the UK, Canada, Australia, Germany, France, Japan, New Zealand and five
Nordic countries).
66 Joint Working Group of Standards Setters, 2000: §1.7.
67 Ibid.: §1.28.
68 Ibid.: §1.8a.
64
19
as profits or losses, ensuring that management’s freedom to hide changes in firms’
financial position should be severely restricted. 69
This FFVA model was different from the so called ‘mixed model’ that had hitherto
been common practice in the financial sector. In this model, only financial
instruments held for trading purposes were measured at fair value while those
intended to be held to maturity were measured at historical cost. This model, which
was also underlying IAS 39, was deemed inadequate by the JWGSS:
Existing mixed cost-fair value accounting for financial
instruments is not sustainable in the longer term, and cannot
provide a satisfactory basis for financial accounting, because
it is based on mixing elements of two incompatible
measurement systems for financial instruments. 70
Depending on asset categorization by banks, similar assets would appear in balance
sheets with different value – anathema to the kind of transparency favored by the
standard setters.
Unsurprisingly, banks opposed the idea of FFVA and preferred the mixed model,
which gave them the leeway to categorize assets in line with their own business
models and interests. The JWGSS had been well aware of this opposition, and during
its work it consulted with banking representatives and even issued a separate paper
on issues relating to banks. 71 To make a strong fist, however, banking associations set
up a parallel working group that issued papers spelling out the banking industry
position. This Joint Working Group of Banking Associations (JWGBA) comprised
the banking associations of the USA, Australia, Canada, Japan and the EU. In 1998 it
sent a letter to the IASC/JWGSS stating that the latter’s desire to move to FFVA
was not backed by compelling evidence of user or preparer support and did not
adequately deal with the objections raised to it. 72
In October 1999, the JWGBA issued a paper claiming that ‘the mixed measurement
system provides the optimal means of reporting financial performance’ – a
Ibid.: §1.5b.
Ibid.: §138a.
71 Joint Working Group of Standards Setters, 1999.
72 Ibid.: §2.1.
69
70
20
contestable claim, as outlined above. 73 Contrary to the JWGSS line of argument, the
JWGBA claimed that established accounting practices already met the needs of users
of banks’ financial statements. Banks practiced two fundamentally different activities:
traditional banking activities (credit intermediation) and trading activities. While fair
value accounting might be suitable for the latter, it was not for the former, so the
JWGBA claimed. Fair value measurement of long term loans was seen as inadequate
as it overemphasized short-term market volatility that did not correspond to the
underlying economic rationale of these instruments.
That said, it was clear from the outset that the main concern of the banking
community was not the perceived intellectual inadequacy of fair value accounting for
traditional banking activities, but rather the implications of such accounting for
banks’ income statements. Banks argued that the volatility that FFVA would
introduce into their financial positions would undermine public confidence and
adversely affect banks’ ability to perform credit intermediation. In short, banks were
not in favour of one or the other methodology per se; they were in favour of an
accounting system that corresponded to their own business model at any given time,
effectively letting valuation of assets depend what was most opportune from a
business standpoint. In the end, application of competing measurement instruments
would be contingent on overall market conditions.
Banking regulators and prudential supervisors shared banks’ professed concern about
excessive volatility as a result of FFVA. The Basel Committee on Banking
Supervision (BCBS), for instance, expressed its concern about the JWGSS proposal
and argued that the time was not ripe for the prescription of FFVA. 74 According to
the BCBS, while FVA was clearly appropriate for trading activities, there were still
too many practical difficulties with fair value measurement of banking book
instruments. 75 The BCBS also expressed unease about the significant volatility that
could be introduced into bank accounts. 76 Moreover, as accounting practices
influence business decisions, the wider micro- and macro-economic effects of a new
Joint Working Group of Banking Associations, 1999: 2.
Basel Committee on Banking Supervision, 2001: §1.4.
75 Ibid.: §3.1.
76 Ibid.: §3.8.
73
74
21
accounting framework would have to be assessed before introducing such a new
framework. At the same time, the BCBS acknowledged that mixed measurement
models were far from perfect, also due to the necessity of complex hedge accounting
provisions, which later turned out to the Achilles heel of the whole mixed model (see
below). Hence, a move towards FFVA in the long term should not a priori be
discarded, even if in the short run the mixed model was deemed to be more
appropriate. In a nutshell, the BCBS found itself in a dilemma, acknowledging both
the potentially deleterious consequences of FFVA and the weaknesses of the mixed
model. Without any idea in which overall direction to develop accounting standards,
it simply urged standard setters to address problems in the mixed model as they arose
without, however, abandoning it altogether.
The IASB, in its summary of the comment letters on the draft standard that were
received, concluded that most of the preparers strongly opposed FFVA and the
immediate recognition of the resulting gains and losses. Opposition to the JWGSS
proposal proved to be so fierce that the project was temporarily abandoned by the
IASB – a move that dovetailed with the BCBS’ skepticism about FFVA without,
however, addressing its doubts about the mixed model. IAS 39, which the IASB had
originally intended to replace by a much more coherent standard, hence became the
point of departure for all subsequent debates. Unsurprisingly, the latter emerged
before long, given that the impossibility to agree on a replacement for IAS 39 did not
mean that its own inconsistencies had vanished.
Episode II: The IAS 39 controversies (2002 – 2005)
On the face of it, the shelving of FFVA was a victory for the banking community.
Banking supervisors had been equally uneasy with the approach, however, given its
potential implications for bank and hence financial system stability. That said, both
banks and supervisors leveled strong criticism against the mixed-measurement IAS
39, which had now become the default standard. The matter gained urgency in 2000
when the European Commission announced its intention to require companies listed
in the EU to use international accounting standards. 77 This requirement was
formalized in a regulation in 2002 that prescribed the use of IAS by 2005. Suddenly,
77
Cf. Dewing and Russell, 2004.
22
IAS 39 was no longer simply an object of theoretical debates but became of utmost
importance to European listed banks, their regulators and national and EU political
agencies.
The main point of conflict between standard setters, banks and public regulators was
accounting for derivatives. The principles underlying IAS 39 held that all financial
instruments should be on the balance sheet and that
fair value is the most relevant measure for financial
instruments and the only relevant measure for derivatives.
(…) In accordance with this principle, almost all derivatives
falling within the scope of IAS 39 are measured at fair
value. 78
Previous accounting practices in Europe did not require all derivatives to be on the
balance sheet, let alone to be measured at fair value. As derivatives’ value can
fluctuate significantly in a short period of time, the resulting volatility in banks’
financial positions was again a major concern. 79 Banks hitherto dealt with this
volatility by a special practice called hedge accounting, in which income fluctuations
due to changes in the value of derivatives could be removed by recognizing
fluctuations in other, linked instruments that would otherwise be measured at
historical cost. 80 However, the IASB introduced strict rules for so-called ‘special
Hague, 2004.
Some observers argue that in fact the mixed model introduces artificial volatility, especially when it
concerns derivatives. As stated above, derivatives are instruments the value of which depends on
some other underlying instrument. If an institution owns a derivative that is linked to another
instrument on the balance sheet and if both instruments are measured at fair value, the shift in the
value of one instrument would be offset by an equal shift in the value of the other, creating no
volatility in the income statement. In a mixed model, it is possible that the derivative is measured at
fair value and the other instrument at historic cost, meaning that shifts in value are not offset and
hence create artificial volatility not corresponding to the underlying economic logic. See e.g.
Whittington, 2005: 137.
80 A hedge is created when the shift in value of one instrument is offset by an equal shift in value by
another instrument in the opposite direction. Hedging thus is a strategy to offset risk. Banks often use
derivatives to create hedges, as these instruments by definition depend on the price of another
instrument. Hedge accounting involves designating a derivative (measured at fair value) as a hedging
instrument and other items as the hedged instruments (measured at historical cost). Changes in the
value of the derivatives are allowed to be offset (in equity or in income) by recognizing an equal
change in the value of the hedged instruments, thereby generating no volatility in either income or
equity.
78
79
23
accounting’, ensuring that such practices would be allowed only in clearly defined
circumstances. 81
Banks strongly opposed the strictness of the new hedge accounting provisions,
arguing that they did not correspond to long-standing banking practices. Accounting
techniques, so the basic idea, should adapt to banks’ risk management –challenging
the whole notion that corporate accounts summarize the combined values of a
company’s individual assets and liabilities. Especially French banks feared the
consequences of the recognition of all derivatives and their measurement at fair
value. Jacques Chirac, French president at the time, sent a letter to the European
Commission in 2003 claiming that ‘IAS 39 could have nefarious consequences for
Europe's economies’. 82
Banks again received backing from the BCBS, as the committee feared that banks
would abandon established risk management practices due to new hedge accounting
rules. At the same time, the committee found it undesirable to have standards be so
flexible as to open the door for the manipulation of the firms’ financial positions. 83
According to the BCBS, hedging strategies should be clearly identifiable, measurable,
effective and adequately documented in order for hedge accounting to be
appropriate. At the same time, it remained concerned about the overly burdensome
and stringent requirements imposed by IAS 39 that might deter banks and other
companies from prudential risk management strategies. 84 Banks might snub positions
that would be adequate from a risk management perspective but uncertain to qualify
for hedge accounting. In short, the supervisors wanted banks to have flexibility but
also to make sure that that flexibility would not be abused – a circle that remained
impossible to square.
The main point of controversy turned out to be restrictions on hedge accounting for
derivatives that banks used to hedge interest rate risks in their banking book: socalled macro-hedges. Banks were used to hedging risks using derivatives meant to
cover net risk exposures, rather than hedging (potentially offsetting) exposures one-
Hague, 2004: 24.
Parker, 2004: 24.
83 Basel Committee on Banking Supervision, 2002: 5.
84 Ibid.
81
82
24
by-one. Leaving technical details aside, having the macro-hedge qualify for hedge
accounting would make it easier for banks to defer recognizing changed derivatives
values as profits or losses, thereby reducing volatility. 85 The IASB was of the opinion
that there should exist a clear link between the hedging instrument and the hedged
instrument before hedge accounting could be permitted; otherwise management
would have too much freedom to manage income and to hide losses and gains.
These conflicting positions led to a series of meetings between the IASB and
representatives of banks from Germany, France and the UK in the course of 2003.
These meetings resulted in a narrowing of the distance between the opposing parties.
However, on key issues, such as on effectiveness testing, no agreement could be
found, which meant that using hedge accounting would still be very difficult for
banks under IAS 39 rules. In 2004 efforts were therefore made from all sides to have
the IASB relax its rules on hedge accounting. Big banks intensely lobbied the IASB –
both individually and through the European Banking Federation – but to no avail.
The European Financial Services Round Table (EFR), a trade association of mostly
continental European banks and insurers, shifted its focus on the European
Commission, hoping that the latter might have enough leverage to enforce an
agreement. In a letter the EFR sent in February, it stated that ‘the current proposals
do not reflect economic reality, create artificial and undue volatility on earnings and
equity and would lead to misinterpretation of financial statements’.
86
The
Commission had already threatened that it would not endorse the IASB’s derivative
standards unaltered, and set a deadline for a solution in June.
The controversy remained unsolved, and by mid-June four countries (France, Italy,
Spain and Belgium) expressed their opposition to a complete endorsement of IAS
39, with six others (including Germany) undecided. 87 EFRAG, an advisory body to
the Commission on issues concerning accounting standards, also said it could not
recommend full endorsement. 88 The Commission resolved that it would only
partially endorse IAS 39, with controversial sections in the standard concerning
Parker, 2003.
European Financial Services Roundtable, 2004.
87 Dombey, 2004.
88 Walton, 2004: 6.
85
86
25
hedge accounting ‘carved out’ by the EU’s Accounting Regulatory Committee
(ARC). 89 The carved-out version was finally endorsed in the EU at the end of 2004.
The EC stressed that this was only a temporary solution to a temporary standard and
expressed its hope that the underlying problem be solved by the end of 2005. 90 The
ECB claimed that the carve out clearly did not represent an optimal long term
solution. 91 The ‘solution’ was suboptimal both from the perspective of standard
setters as well as the prudential regulators; still, the fear that banks might abandon
‘sensible’ risk-management practices and that ‘ineffective hedges’ might lead to
income volatility led public regulators to side with banks eventually. This alliance was
not an incidence of ‘traditional’ regulatory capture, however. On hedge accounting
supervisors sided with banks because their own interest in financial stability might be
compromised if any one accounting methodology would be applied too stringently.
On the other key issue, the so-called Fair Value Option (FVO), the supervisors were
ready to face off bank lobbying because competitiveness issues could be effectively
disentangled from concerns about financial stability.
The section dealing with the FVO was a second central part of IAS 39 that was
‘carved out’. This option had been proposed by the IASB in 2002 and introduced
into an amended version of IAS 39 in December 2003. The FVO allowed the
measurement of any financial asset or liability at fair value, with changes in value
recognized as profits or losses, provided that the instrument was designated in the
FVO category on initial recognition. 92 As IAS 39 was a mixed standard and certain
‘natural hedges’ would not be recognized as such because of different accounting
treatments, the FVO allowed for recognizing offsetting fluctuations without having
to resort to complex and burdensome hedge accounting. 93
Interestingly enough, whereas the debate on hedge accounting provisions of IAS 39
showed the IASB’s worries over giving banks too much accounting freedom, the
Individual EU countries were in principle free to demand full application of the standard.
European Commission, 2004.
91 European Central Bank, 2006: 24.
92 Whittington, 2005: 139.
93 If hedge accounting rules did not allow the recognition of offsetting fluctuations of instruments that
were valued on a different basis, then the FVO might still allow a bank to value the hedged instrument
at fair value, meaning that treatment of the hedge and the hedged items would match once more.
89
90
26
initial FVO proposal would have provided banks with just that, even though the
option was irrevocable, meaning that no reclassification would be allowed.
Apparently, the IASB’s wish to move to a fair value system was so strong that it
accepted the possible consequences that the same instruments would be measured
differently by different institutions and that accounts would become less comparable.
Banking regulators and the European Central bank, however, remained doubtful
about the FVO. 94 The BCBS acknowledged that it might resolve some problems of
the mixed measurement attributes of IAS 39, but it claimed that the FVO might
generate similar problems to FFVA by allowing institutions to record a profit when
its own creditworthiness deteriorated through fair-valuing liabilities, as discussed
above. 95 Moreover, for financial instruments that lack reliable fair values, for example
due to the absence of market prices, ‘this option may permit companies to manage
earnings in ways that would not easily be detected by financial statement users’. 96
From a financial stability perspective the regulators feared that outside parties such as
institutional investors would pressure banks gradually to extend the area of
instruments to be fair valued, which de facto would mean a move towards FFVA,
which would reintroduce the concerns about volatility in the banks’ income
statement and in the financial system at large. 97
The IASB was responsive to this concern and issued a new exposure draft in March
2004 in which a more restrictive version of the FVO was proposed, much to the
chagrin of banks. The European Banking Federation argued that the FVO would
allow entities to overcome the basic flaws of IAS 39 and reduce income volatility as
natural hedges could be recognized as such. 98 The London Investment Banking
Association (LIBA) called the unrestricted FVO a ‘key cornerstone’ and expressed its
‘disappointment that the Board is now proposing to amend this accounting
Cf. European Central Bank, 2006.
Basel Committee on Banking Supervision, 2002.
96 Ibid.: 2.
97 Enria, Cappiello, Dierick, et al, 2004.
98 European Banking Federation, 2004.
94
95
27
guidance’. 99 The industry responses to the proposed limitations were overwhelmingly
negative. 100
At the time of IAS 39 endorsement – at the end of 2004 – an adequate new version
of the FVO had not been finalized. Hence the original, very permissive FVO
provisions were also ‘carved out’, causing despair among banks who coveted the
FVO freedom. In the first half of 2005, the issue was finally resolved in line with
banking supervisors’ demands. In the new version, the option could only be used to
eliminate or reduce significantly an ‘accounting mismatch’. Alternatively, entities
would have to document clearly that instruments were managed with a specific risk
or investment strategy and support FVO application by adequate disclosure. 101
Taken together, the controversies about hedge accounting and the FVO show how
regulators and supervisors were not simply doing the banks’ bidding – even when the
latter largely agreed with the line set out by the IASB, as in the case of the FVO.
Rather, the supervisors’ position tried to balance banks’ accounting flexibility as a
precondition for financial stability (in hedge accounting) with sufficiently strict rules
lest banks could misrepresent their financial situation, and hence hide mounting
problems from supervisors and investors. The deal that was struck represented an
uneasy truce between stakeholders and competing arguments as discussions reached
an impasse rather than any durable solution.
Episode III: The financial crisis and IFRS 9 (2007 – 2009)
The ‘messy’ solution that had been found through the IAS 39 modification managed
to calm nerves over derivatives accounting temporarily, largely because propitious
financial condition until mid-2007 prevented any real problems from emerging. As
the credit crisis started unfolding after the summer of 2007, accounting for financial
instruments once again climbed on the political agenda. The crisis triggered two
moves by the IASB: it modified IAS 39 once more, and it started to develop a new
standard (IFRS 9) to replace IAS 39 eventually. Both moves again exposed the
fundamental dilemmas faced by the stakeholders involved.
London Investment Banking Association, 2004.
EFRAG, 2004.
101 European Commission, 2005.
99
100
28
As the credit crunch developed into a full blown financial crisis, fair value accounting
came under fierce attack. 102 Banks complained that FVA forced them to treat falling
asset prices as losses even when they had no intention of selling the assets in
question. They also expressed concern that in an environment of illiquid markets, the
fair value of assets was impossible to ascertain, thereby heightening market
uncertainty. Finally, banks as well as regulators argued that FVA induced pro-cyclical
behavior, with falling asset prices triggering sales and curbs on lending, which
themselves induced further falls in assets’ market values.
The extent of recognized bank losses under IAS rules triggered intense bank
lobbying of the IASB. EU member states, with France and Germany leading the way,
urged the IASB to modify IAS 39 to create some breathing space for banks. The EU
message to the IASB boiled down to a threat that ‘either you change the rules, or we
will’. Already a new version of IAS 39 containing a draft carve out was circulating,
following an initiative of French president Sarkozy. 103 The pressure on the IASB was
so intense that it decided to modify the standard in October 2008, allowing for the
reclassification of assets into categories that did not require market-based
valuations. 104 The fact that the IASB gave in to EU pressures, and that it did not
follow its normal stakeholder consultation practices, was criticized by investors and
accountants, but the threat of an EU changing rules in defiance of the IASB was
simply too great. Yet another carve-out would have been disastrous for the authority
of the IASB, although giving in to the threats proved to be a severe blow as well. The
IASB defended its move by claiming that the modification ensured at least some
transparency on reclassifications, which would not have been required had the EU
simply removed the provisions in the IAS 39 standard.
The necessity of a modification of IAS 39 shows the dire situation in which public
actors found themselves. The sudden claim that particular assets were long-term
investments, even though no complaints had been heard about irrational valuations
Casabona and Shoaf, 2010.
André, Cazavan-Jeny, Dick, Richard, and Walton, 2009.
104 The EU regulation requiring the use of IAS stated that the standards should not disadvantage
European companies as compared to those in other major markets. It was argued that as
reclassification in ‘rare circumstances’ was allowed in the US, this should also be allowed in the EU.
Ibid.
102
103
29
when market prices went up, was hard to stomach for many observers. The problem
went deeper, however. Standard setters had an obvious point claiming that falling
assets prices reflected poor investment decisions of banks. And allowing banks to
defer recognition of losses is problematic from a prudential perspective, as the
Savings and Loans crisis in the US in the 1980s and the ‘lost decade’ in Japan in the
1990s clearly showed. At the same time, the danger of credit intermediaries
imploding was even more severe and triggered demands for rule modification,
allowing banks more freedom to choose ‘appropriate’ valuation techniques for their
assets.
The second key move of the IASB was to start development of a new standard to
replace IAS 39. In March 2008, the IASB had issued a discussion paper to explore
how accounting for financial instruments could be improved, referring to the
perceived complexity of IAS 39 as a main motive for such a revision. The IASB
argued that in the long term, a move towards a single measurement method would
significantly reduce complexity, and that fair value was the most appropriate method
in this respect. Hence, the IASB argued for a long-term move towards full fair value
accounting, effectively going back to the position it had taken a decade earlier.
Not surprisingly, strong opposition from banks followed. The crisis had also changed
the perspective of regulators, however. Now they clearly pointed to a mixed model as
the most desirable option; any move to FFVA, even in the long run, was out of the
question. These responses echo the positions that had been taken more than a
decade earlier during the Joint Working Group controversy (Episode I). The
International Banking Federation reiterated that a mixed system was more suitable
for banks than FFVA. 105 Most other banks, with a small number of investment banks
as an exception, supported this line, as did the Committee of European Banking
Supervisors, the EU’s banking watchdog, and the BCBS.
Under pressure of the G20 and countries such as Germany and France, who quickly
wanted to see a new standard in which fewer financial instruments were measured at
fair value, the IASB had pledged to speed up its revision process and to issue a new
International Banking Federation, 2008. The International Banking Federation is the representative
body for a group of banking associations, which include the American, Australian, Canadian, Chinese,
Indian, Japanese and European banking associations/federations.
105
30
standard (IFRS 9) by the end of 2009. 106 When a draft version was issued in July
2009 the IASB made clear that as there were conflicting views and issues to be
resolved,
the Board decided that measuring all financial assets and
financial liabilities at fair value is not the most appropriate
approach to improving the financial reporting for financial
instruments. 107
Instead, the standard’s main difference compared to IAS 39 was that there were
fewer accounting categories, the choice being between historical cost and fair
value. 108 In the IASB’s draft proposal, the characteristics of the instrument in
question itself should be the main classification criterion and subsequent
reclassification should not be permitted. In contrast, the European Banking
Federation argued that the ‘business model’ (i.e. the way in which the instruments are
managed) should be primary in classification decisions, with the characteristic of the
instruments being secondary. 109 Going further, reclassification should be mandatory
if the circumstances required that. The BCBS came to broadly the same conclusions,
but it also emphasized that the ‘business model’ should be supported by clearly
documented risk management strategies and that reclassification should only be
allowed in case of ‘events having clearly led to a change in business model’. 110 Out of
a shared concern for financial institutions’ viability, banks and their regulators argued
in the same direction; at the same time, regulators remained steadfast not to grant
banks too much freedom in asset (re)classification.
In the final standard, issued in November 2009, banks have increased freedom to
classify particular assets in the historical cost category, and reclassification is required
106 Actually, the revision would take place in three steps. The new standard, IFRS 9, would be
introduced at the end of 2009 and then further developed, and would have to be adopted by January
2013 at the latest, with early adoption being permitted starting in 2009. The first stage would deal with
classification and measurement of financial instruments (finished by the end of 2009), the second
stage with the ongoing measurement and impairment methodology and the third stage with hedge
accounting (both to be finished by the end of 2010).
107 International Accounting Standards Board, 2009: BC13.
108 In IAS39 there were four accounting categories for financial assets: (1) for trading instruments (fair
value through income statement); (2) instruments available for sale (fair value through equity); (3) held
to maturity (historical cost); and (4) loans and receivables (historical cost).
109 European Banking Federation, 2009.
110 Basel Committee on Banking Supervision, 2009: 1f.
31
when the ‘business model’ changes. 111 Nevertheless, the EU refused to adopt the
standard, triggering shock reactions from around the world. Numerous Continental
banks were sitting on piles of losses that had yet to be recognized in the income
statement. According to Tait and Sanderson, ‘French, German and Italian banks with
large investment banking activities would be hit disproportionately by the changes,
forcing them to book losses on large holdings of derivatives’. 112 After more than a
decade of going back and forth on accounting for derivatives, still no satisfactory
solution had been found. The tension between banks’ need for flexibility in the name
of financial stability on the one hand, and the potential for abuse of that flexibility on
the other, remains unresolved. If banks and their regulators have repeatedly found
themselves on the same side of debates over accounting reforms, then it has been the
impossibility to resolve this tension more than anything else that has brought them
together.
CONCLUSION
This paper has tried to unpack the convoluted politics of accounting standard setting
over the past two decades and in particular the struggle over FVA. In contrast to
traditional political economy accounts of such politics, which emphasize conflicts
between actors with identifiable power resources and clear interests, our account has
highlighted the contingency of stakeholders’ policy preferences and the shifting
alliances concerning accounting standards.
The ultimate driver of this dynamic lies in the indeterminacy of values of financial
assets itself. The application of any given valuation technique not only measures the
economic present but also shapes the economic future. Such techniques are
necessarily faulty, and as we argued, none of the available ones can provide the
financial stability that public authorities covet. Hence, public actors find themselves
endorsing temporary solutions that turn into permanent ones and half-baked
The change in business model is quite restrictive, however: it should be the ‘result of external or
internal changes and must be significant to the entity’s operations and demonstrable to external
parties’ Moreover, ‘a change in intention related to particular financial assets (even in circumstances of
significant changes in market conditions)’ or ‘a temporary disappearance of a particular market for
financial assets’ do not qualify for a ‘changed business model’. International Accounting Standards
Board, 2009: §§ B 5.9-5.11.
112 Tait and Sanderson, 2009: 19.
111
32
measures for want to convincing solutions. More importantly for our account, just as
the specific preferences of banks themselves (when they want to apply FVA and
when they do not) change over time, so do the preferences of those in charge of
their stability. The politics of accounting are contingent on overall market and
economic conditions – which themselves, as the credit crisis has demonstrated, can
be driven by the regulations and accounting techniques that shape financial markets.
Beyond the domain of accounting itself, this paper has demonstrated how theories
from heterodox economics can inform modeling the policy preferences of actors in
financial governance. Even though this paper has concentrated on accounting, this
argument should in principle be applicable to other domains of financial regulation in
which the contingencies of valuation generate policy challenges. The regulation of
credit rating agencies is an example: post-crisis reform proposals on both sides of the
Atlantic have dodged the question of how ratings as assessments of credit worthiness
could be detached from their own impact on market functioning.
With its emphasis on contingency and the importance of human cognition to
financial market functioning and hence policy preference formation, this paper
clearly links to constructivist scholarship in IPE. 113 At the same time it shows that
that need not put it out of touch with the strengths of open economy politics, which
uses economic scholarship to theorize the preferences of actors in the political
economy. We hope that this paper will be read as one example of how the two
traditions can be fruitfully integrated.
113
Abdelal, Blyth, and Parsons, 2010.
33
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