EU: Following the U.S. Accounting Lead

EU finance ministers meeting on April 4 in Prague called for a Europe-wide relaxation of accounting norms to match recent U.S. moves to give banks more room to maneuver and make more credit available for lending. The ministers' decision follows the April 2 move by the U.S. Financial Accounting Standards Board (FASB) to change the "mark to market" accounting standards, allowing banks to revalue their assets not on the basis of current value, but on that of potential future sales or if held to maturity. Mark to market conforms to the internationally recognized generally accepted accounting principles. Its main purpose is to value assets on the basis of the price they would fetch if sold at the prevailing market price at the time of their valuation, not on the price the bank paid or the price the bank would get if it sold them down the road. But in times of financial crisis, many financial institutions are forced to raise capital by selling various assets. As the market is flooded with assets, their current prices go down, lowering the book value of assets held by financial institutions across the board. Banks are required to hold a substantial portion of assets in liquid form (i.e., readily exchangeable for cash), and as asset prices go down, even banks in good standing suddenly find themselves with less value in their assets — and are therefore forced to raise more capital to maintain their asset-to-loan ratio. The end result is a cascade of distress sales that leaves banks, even well-run ones, technically insolvent (or close to it) and unable to lend. This leads to a credit crisis when banks stop lending to make up their losses in asset value. The U.S. rule change means that financial institutions can now determine the value of assets backed by real collateral, such as mortgage-backed securities, on the basis of what they expect to earn over the long haul. With a single decision, the FASB has thus breathed life into financial institutions by allowing them to transform many of the so-called "toxic assets" into valuable assets. This has given U.S. financial institutions a chance to mend their balance sheets, and thus more room to lend. The EU decision is therefore intended to avoid "competitive distortions," where the U.S. banks suddenly count their market-depressed assets as valuable (and can restart lending) while their European counterparts still consider the assets as toxic, and thus have to hoard capital. The EU finance ministers have agreed to call on the London-based International Accounting Standards Board, a rule-setter for accounting practices in Europe, to cooperate with the FASB in adopting similar rules in Europe. The EU finance ministers are adamant that the rule change must be adopted quickly, with Italian Finance Minister Giulio Tremonti saying that if it were his decision, he would "download the U.S. text with Google and adopt it with a European blessing." Of course, all the EU finance ministers can do is recommend that all 27 member states mirror the FASB and hope that the bloc moves in unison. Luckily, this time around everyone seems to be on board and starting on the same page.