In its generally gloomy Financial Risk Outlook 2008, the UK’s Financial Services Authority cautions that efforts to improve the valuation of exotic financial instruments such as structured investment vehicles could backfire if not handled correctly.
The FSA notes that the Financial Stability Forum’s Working Group on Market and Institutional Resilience is coordinating international work on the implications of recent market conditions for valuing assets and liabilities. “There is, nonetheless, a risk that bodies other than accounting standard setters might seek to set what would, in effect, be accounting rules, which could be inconsistent with sound accounting practice. This could lead to reduced market confidence in the accuracy of financial information.”
For example, some might favour applying valuation adjustments made for prudential purposes to financial reporting, or requiring firms’ financial statements to value assets conservatively on the basis of an assumption of stressed, rather than normal, market conditions, or loanloss provisions to be set significantly above losses actually incurred to provide a margin of prudence.
The report provides a good summary of the use of fair value in accounting for financial instruments under International Financial Reporting Standards (IFRS) and US Generally Accepted Accounting Principles (GAAP).
The FSA sees the following “Priority Risks for 2008:
- Existing business models of some financial institutions are under strain as a result of adverse market conditions.
- Increased financial pressures may lead to financial firms shifting their efforts away from focusing on conduct-of business requirements and from maintaining and strengthening business-as-usual processes.
- Market participants and consumers may lose confidence in financial institutions and in the authorities’ ability to safeguard the financial system.
- A significant minority of consumers could experience financial problems because of their high levels of borrowing.
- Tighter economic conditions could increase the incidence or discovery of some types of financial crime or lead to firms’ resources being diverted away from tackling financial crime.