The accounting method used affects reported earnings, book value and the value for Tier I capital as defined in the Basel Accord. Under US GAAP banks are permitted to use both the carried-at-cost and mark-to-market methods. From an economic value perspective this is clearly nonsense. The same security held in different accounts will be valued in different ways based on intent!
A bank could have holdings in an identical bond booked in three different accounts based on “intent”. If the intention is to hold the bond to maturity it is included at cost. If booked as “available- for-sale” the asset is held on the balance sheet at current market prices with unrealized gains or losses included in a reserve account within the equity account. If the bond is counted as a “trading security” the bond is marked to market with any gains or losses taken through the earnings statements. Finally, if the bank had raised finance itself by issuing its own bond with identical economic characteristics as the bond held as an asset this will be carried at cost.
The rigorous application of accounting standards results in book value numbers that are precise but have limited real meaning (although they are of consequence). Numbers that reflect economic value, by their very nature, should be approximate and based on estimates but would at least have a real significance.
Most banks have argued against compulsory mark-to-market accounting on the basis that it will result in more volatile reported earnings, book value and level of reported regulatory capital. So what? External auditors usually sign off a company’s accounts with a statement along the lines of “these financial statements give a true and fair view of the state of ABC Bank as of December 31 2006 and of the profit of ABC Bank for the year then ended”. If the economic reality is volatile then this should be reflected in financial statements and management should be prevented from trying to hide this fact through accounting obfuscation and obstruction.
The main criticism of those efforts that have been taken to make reported book value reflect economic value better is that they did not go far enough. The main area where there has been some progress in this direction has been in the treatment of traded securities. It is difficult, however, to see the sense of taking just selected parts of the interest rate-sensitive portion of a bank’s balance sheet and marking them to market, while ignoring the much larger proportion held in loans and also non-equity liabilities such as bonds that a bank has issued.