BankUnder the “Fair Value Option,” accounting rules allow a bank to book income when its debt has declined in value should they elect fair value accounting for their debt. Once adopted, the decision is irreversible.

Now consider a bank whose financial health has been deteriorating (a decline in credit ratings or an increase in credit default swap spreads). Under accounting rules, a financially constrained bank would record an accounting gain! Therefore, other things remaining unchanged, a healthy bank would report a loss on the income statement, while an unhealthy bank would report a profit on the income statement. Very counter-intuitive.    

Prominent Example

In 2011, JP Morgan Chase in its third quarter earnings reported a whopping $1.9 billion pretax gain because of debt valuation adjustments (DVA), i.e., it recognized a gain because the market value of its publicly traded debt had decline in value. Similarly, in the first quarter of 2012, Morgan Stanley ’s earnings were reduced by nearly $1.5 billion in losses which were tied to this rule. In the third quarter of 2011, the bank had a gain of $2.1 billion because of debt valuation adjustments. In the nine months of 2015, Morgan Stanley recorded a gain of $477 million related to the DVA rule.

You can notice the volatility in earnings that results from valuing debt at fair value. Moreover, the recording of the debt value adjustment on the income statement made it difficult for investors to value a bank’s earnings.

Background

In 2008, when the accounting rule first came into play, which coincided with the financial crisis, banks were only too keen to adopt the fair value option for valuing their own debt. This is because, with overall deteriorating health, banks were able to mask their economic performance by booking a large accounting gain which arose from a decline in the market value of their own debt.

The Great Escape

Based on investor feedback, the US accounting rule-making body, FASB, is finally giving banks an “opt out.” Going forward, if a bank elects to adopt fair value accounting to value its own debt, it does not have to report any gain or loss from decline or rise in its market value of debt on its income statement. Instead, the gain or loss related to debt valuation adjustment is to be reported under “other comprehensive income,” which is not included in the income statement.

Accountability of accounting in banks!

February 16, 2016; 4.30P

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