Further to my essay on Mark to Market, here's a nice article on an arcane aspect of it. I quote:
“Fair” values for bank assets could be different for accounting and regulatory purposes, the UK regulator has warned, in a move that could see banks forced to top up their capital reserves.
The Financial Services Authority has held “round table” meetings with banks and leading auditors to discuss the issue as part of its scrutiny of valuation techniques in the current market turmoil.
Although the FSA has not changed its rules, officials have warned banks to take extra care over their regulatory valuations.
Both regulators and accounting systems rely on “fair” or market value of assets. Regulators then require banks to adjust the accounting number, if necessary, to more closely reflect actual liquidity. In today’s markets this is most likely to involve booking assets at potentially steep discounts to the current price if that amount is unlikely to be realised when the whole asset is sold.
Accounting standards previously included this notion, known as the blockage factor.
The most common example is discounting some of the total value of a large shareholding since selling the entirety in one go would depress the market, meaning the bank could not realise the full price per share that the holding was worth technically.
“The FSA made the point they are concerned about prudential valuation,” said one person present at the meetings.
“They recognise that in normal markets both values might be the same but when liquidity dries up, they might well diverge. Their focus was around the risk of uncertainty around valuations like asking what would happen if mortgage default rates rose further.” If a bank lowers its valuation reckoning on a particular holding, it could weaken its regulatory capital reserves.
The FSA’s research stemmed from work commissioned by the Basle committee on bank regulation.
At the meetings, regulators also presented their research into banks’ efforts to value securities in illiquid markets.
The general conclusion was that the models being used had improved.
“[The FSA] wasn’t as explicit as saying ‘things are either getting better or worse’, but it is fair to say all banks’ processes are getting better,” said one senior financial services auditor. “Like anyone living through a crisis you’re going to learn something from it.”
As markets seized up and prices became harder to find for many securities, banks have been forced to develop a number of new models to value their holdings in the third quarter of last year and have improved them since, auditors said. The FSA’s report contained nothing that surprised them, they added.
The recent meetings were the second involving auditors from all the biggest firms, who welcomed the FSA’s role in convening the groups.
“We can only look at our own audit clients and they can look at a wider range of firms, which is helpful,” said one attendee. “The fact they’re engaging with us on this is a positive development.”
All this to be taken with a grain of piquant salt!!!