Peeling away financial reporting issues one layer at a time

The FASB Could Rescue the Financial System – But It Won’t

If you want to understand the causes of the financial crisis from 25 pages instead of the 600 pages burped up by the FCIC, then read this: Understanding the Subprime Financial Crisis, by Duke Law professor Steven L. Schwarcz. I also like this paper very much because the final section cogently reduces the oft-recited litany of a cascading series of value-destroying events to four fundamental vulnerabilities. Schwarcz's premise is that awareness of these vulnerabilities provides a framework for thinking about what should be done to avoid future crises.

My premise is that much of what can and should be done involves radical reform of accounting standards. That's why I am disappointed that both the Schwarcz paper and the FCIC report (albeit Schwarcz slightly less so) fail to discuss to any degree how politically-jiggered accounting standards facilitated the financial crisis; and critically, how simpler yet more robust standards could make the future much more secure. Notwithstanding this shortcoming, Schwarcz's paper at least provides little ole me with a foundation for discussing how improvements to financial reporting could be the most significant reform we undertake in response to the third financial crisis in twenty years.

Let's take Schwarcz's list of vulnerabilities one at a time:

Conflicts of Interest

This first category, conflicts, has a number of dimensions, such as information asymmetry issues between mortgage lenders and investors in securitized mortgages. These would seem to be curable by disclosure reforms, and the SEC has been focusing on replacing reliance on credit rating agencies with enhanced disclosures. However, Schwarcz sees another problem, "super large" compensation payouts, to be less tractable:

"[If] an individual's compensation, even if it were to be fully adjusted downward [i.e., clawed back or contingently paid over time], still enables that individual to be financially independent of the firm, then that individual's incentives will not necessarily be aligned with the firm's incentives." [p. 562]

To my view, super large compensation starts at the top, and works its way down. There can be little argument that the accounting, in and of itself, for stock options granted to executives has contributed to the financial crisis, and subsequent events strongly indicate that no reasoned solution has been proposed. So, here's mine.

Relatively recent accounting rules require that at least some of the economic cost of compensation must hit the income statement, but the grant-date measurement rules reveal only the tip of massive payouts to bank executives. Stated another way, the rules provide that "super large" payouts to executives are never matched by super large expense recognition.

The only way for this matching to occur is to treat stock options just like any other derivative written by a company. This would require updating measurements through exercise or expiration, and thereby measuring compensation cost by the actual amount of value transferred. Moreover, exercise date accounting would dovetail very well with the new SEC shareholder "say on pay" rules and the "Compensation Discussion and Analysis" disclosures in proxy statements. Shareholders have a right to know how a particular compensation scheme can be expected to align management's interests with the interests of shareholders when managers have been made financially independent from the firm.

Investor Complacency

"Complacency is a more difficult category because the government cannot change human nature—although it can try to affect behavior." [p. 563]

Complacency exists in part because the certain cost of being anything more than passive is not expected to be offset by the uncertain benefits. The vast majority of investors choose to place their trust in the integrity of the financial reporting regulators – to have put in place a system that clearly signals when financial performance has lagged, or that excessive risks have been taken.

That the accounting standard setters have utterly failed to live up to the trust that investors have placed in them is the overarching theme of this blog. Only the notion of investor complacency can explain why investors have not yet stormed the FASB's headquarters, much as Egyptians demonstrated in Tahriri Square to protest a plutocracy operating behind the façade of democracy and due process.

I have no suggestions for altering the calculus leading to consistent investor complacency. The only solution is for regulators, most especially accounting standard setters, to embrace the reality that investors will not tend to exercise their right to be heard, rather than to exploit that vulnerability. For example, accounting standards should acknowledge that investor preferences dictate that disclosure – even under the best possible circumstances – cannot be an adequate substitute for financial statement recognition. They should also acknowledge that due process is clearly not working even though thousands of comments against a proposed standard have been received from issuers, largely with the objective of drowing out those few investors who care to be heard. 

Complexity of the Modern Financial System

"[T]hings are just too complex to understand. This manifests itself, for example, in the difficulty of achieving transparent disclosure for complicated securities and also in the difficulty of market participants to learn the financial condition of their counterparties (due, for example, to their entering into credit-default swaps). … For the failure of disclosure, investors can partly address this failure by demanding more and better disclosure, including disclosure of contingent liabilities."

I wish Schwarcz and others would also acknowledge that disclosure failures and complexity feed on themselves. To a large extent, financial instruments are complex because they were engineered to be eligible for a particular accounting treatment favored by management: executive stock options, repos, securitizations, credit default swaps – the list can go on forever.

Just imagine how financial reporting would be improved if current values of investments were stated on the balance sheet, all legal rights and obligations were recognized on the balance sheet, and the asset components of contracts (derivatives and otherwise) were presented separately from their liability components. Not only would financial analysis become far less complex due to the add transparency of financial statements, but the financial arrangements themselves would be less complex.

Systemic Risk of Externalities

"[E]ven if [all individual] market participants fully understand that incurring certain risks may contribute to systemic risk, they will not be motivated, absent regulation, to internalize those risks. … [T]herefore, the solution to systemic risk is to impose regulation that internalizes those externalities." [p. 566]

Once again, the accounting standards I have mentioned above could come to the rescue. Mainly, the prudential regulators would have more objective and reliable (albeit extremely conservative) measures of capital adequacy. Though other forms of regulation would still be necessary, we could actually find that we might need fewer regulations than exist currently.

The most generous interpretation of the post-crisis state of financial reporting is that contributions from thinkers like Steven Schwarcz— even though he has little to say about accounting itself—can help accounting standard setters identify opportunities to enhance the safety of capital markets through improved accounting standards.

If only it were so. While the FASB continues to fiddle with convergence ad nauseum, Rome will surely burn … again.

1 Comment

  1. Reply Edith Orenstein February 15, 2011

    Tom,
    Thank you for bringing my attention to the Schwarcz article through your thoughtful post (some parties may not view it as ‘thoughtful’ in the emotional sense but it is certainly well thought out and thought-provoking).
    I have particularly honed in on one section of your post, on a subject I also hold to be extremely important: due process. You state:
    “Only the notion of investor complacency can explain why investors have not yet stormed the FASB’s headquarters, much as Egyptians demonstrated in Tahriri Square to protest a plutocracy operating behind the façade of democracy and due process.
    I have no suggestions for altering the calculus leading to consistent investor complacency. The only solution is for regulators, most especially accounting standard setters, to embrace the reality that investors will not tend to exercise their right to be heard, rather than exploit that tendency. For example, accounting standards should acknowledge that investor preferences dictate that disclosure – even under the best possible circumstances – cannot be an adequate substitute for financial statement recognition. They should also acknowledge that due process is not working just because thousands of comments against a proposed standard have been received from issuers, whose comments vastly outnumber investors’ comments.”
    I would respectfully note (I’m not sure I ‘disagree,’ per se) that:
    – as noted in one of my own blog posts yesterday, due process can be difficult to examine, and one question to consider is whether a flood of identical comment letters (aka to some people ‘form letters’) should necessarily be discounted. I personally don’t think so. If a point is generally agreed upon by tens, hundreds, or thousands of companies (or investors) I do not believe their choice of using an efficient means of communicating their views, even if the template was developed by a member of a business advocacy group — or — an investor advocacy group — should color the substance of the view expressed, nor should the sheer quantity of responses be discounted just because they arrive as ‘form letters.’ Importantly, it is the quality of comment letters (‘form letter’ or not) that should be paramount, in addition to the quantity of comment letters – quantity, for whatever it’s worth, is how democracy is determined.
    But bottom line, I wholeheartedly agree with you about the importance of due process. NOTE: These views are solely my own and not necessarily those of my employer or anyone associated therewith.

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