BoE's Andrew Haldane calls for 'radical rethink' in bank financial reporting

In a speech given at the Information for Better Markets Conference, the Bank of England's Executive Director for Financial Stability and Financial Policy Committee member Andrew Haldane called for a 'radical rethink' in bank financial reporting.

Mr. Haldane noted that

accounting rules for banks have bent with the financial stability wind in ways which have amplified investor and regulatory uncertainty.... But if we are to restore investor faith in banking sector balance sheets, nothing less than a radical rethink may be required.

As evidence of this, he looked at how

fair value accounting principles have gained ground when the going has been good, and lost
it when it has got tough.   From a financial stability perspective, this is a cause for concern.  To see why, consider how banks’ balance sheets then appear to investors.   

During the asset upswing, fair value gains ground.  Mark-to-market gains are booked as profits.  To the extent that asset prices are over-inflated, so too are the recorded profits of the banks.   

During the downswing, fair value principles are rolled back.  Potential losses are then hidden from view.  Today, some of the uncertainty around global bank valuations stems from the difficulty in gauging these losses, obscured by provisioning practices in banking books.  Regulators and investors alike fear the fog created by such forbearance. 

In sum, accounting rules in general, and fair value principles in particular, appear to have played a role in both over-egging the financial upswing and elongating the financial downswing.  They have tended to over-emphasise return in the boom and under-emphasise risk in the bust.  That is not a prudent approach.  Indeed, it is a pro-cyclical one.  

Regular readers know that one of the reasons your humble blogger wants banks to be required to provide ultra transparency is that this disclosure is the perfect complement to bank financial reporting because it eliminates pro-cyclicality.

When banks are required to disclose their current asset, liability and off-balance sheet exposure details, it is impossible for them to hide losses on the downswing, thus eliminating the fog of forbearance, and harder for them to be aggressive in booking mark-to-market gains on the upswing.

Market participants, including their competitors, know how to assess this data and value each position -- after all, many of the loans the competitors tried to book themselves.  As a result, market discipline will force the banks to be conservative in their financial reporting.