Global Financial Crisis in Retrospect [CPA Journal, The]

Consequences and Lessons for the Accounting Profession

In the wake of the 2008 global financial crisis, Congress enacted the DoddFrank Wall Street Reform and Consumer Protection Act of 2010 in order to prevent future systemic meltdowns. As Federal Reserve Chairman Ben Bernanke recently observed, the crisis resulted from failing to pay attention to the entire system ("The Federal Reserve and Its Role in Today's Economy," a speech at The George Washington University School of Business, March 2012); although signs of distress appeared before the collapse, no single agency connected the dots.

More than two years have passed since the enactment of the DoddFrank Act; in the meantime, various federal agencies are assumed to be developing some 400 rules to implement the act. The Dodd-Frank Act mandated that different federal agencies develop specific regulations, regardless of the role those agencies played in the global financial crisis. For example, section 619 of the act calls for the implementation of the Volcker rule, which prohibits commercial banks from using proprietary funds for risky purposes and from owning hedge funds or private equity funds. The rationale is that the government cannot afford to bail out such institutions for their risky behavior. The discussion below revisits the causes of the crisis and considers what has - or has not - been done since then.

Causes of the Crisis

A key problem underlying the global financial crisis was risky behavior by many individuals and institutions, as well as the failure of federal oversight agencies to monitor and control such behavior. In 2011, the Financial Crisis Inquiry Report concluded that the financial crisis could have been averted, had it not been for the inaction of government regulatory agencies, including the Federal Reserve Board (http://www.gpo.gov/fdsys/ pkg/GPO-FCIC); however, the report essentially ignored the valuation of securities and whether fair value accounting contributed to the crisis (Robert Bloom, "The Financial Crisis Inquiry Report," The CPA Journal, May 2011).

The concept of "moral hazard" - in which the party that is incentivized to take risks is not the party that suffers the consequences if those risks do not pan out - laid the foundation for the crisis. Too many parties involved in the mortgage lending supply chain received fees, if not bonuses, regardless of the quality of the loans involved (the more loans, the greater the rewards).

In addition, a dysfunctional emphasis was placed on short-term performance, neglecting the long-term consequences. Credit-rating agencies inconectly assessed the quality of mortgage bonds in order to accommodate the interests of bond-issuing companies. Furthermore, those bonds were based on an amalgamation of housing loans that included the good, the bad, and the ugly; this made the assessment complicated at best.

When credit default swaps (CDS) became the "in" derivative to guard against the risk of buying unsafe mortgage-backed bonds, no constraints were put on this instrument in order to avoid the calamity that ensued. The federal government bailed out AIG - the insurance giant that issued many CDSs, which had numerous counterparties-because the company was considered "too big to fail." In reality, AIG's poor risk management caused the problem; it failed to understand the potentially catastrophic impact of a security that it issued. It should be emphasized that an insurable interest is not required to acquire CDSs; thus, both individuals and companies owning and not owning the bonds in question could acquire CDSs to guard against declines in their value. In addition, not all CDSs called for margin or collateral requirements when the bonds to which they are related experienced a credit downgrade.

Moreover, the federal government was not consistent in its actions toward the companies hit hardest by the crisis. For example, AIG was allowed to survive, but Lehman Brothers was allowed to fail. Bernanke has apparently had second thoughts about the AIG bailout, because it served to perpetuate the aforementioned moral hazard (Bernanke 2012). In the case of AIG, Goldman Sachs was a principal counterparty to the CDSs, benefiting handsomely from the financial rescue without taking a "haircut" on the amounts owed. Goldman Sachs also set up portfolios of CDSs, which it sold to investors without advising them of the subprime mortgage bonds that the CDSs were attempting to hedge. Lehman Brothers was allowed to fail because it was heavily invested in worthless mortgage securities; thus, it was unable to renew its loans.

teps Toward Reform

Section 165 of the Dodd-Frank Act asserts that both a nonbank financial company supervised by the Federal Reserve and a bank holding company with more than $50 billion in consolidated assets must undergo semiannual stress tests. All other financial companies with more than $10 billion in consolidated assets that are regulated by a primary federal financial regulatory agency must submit to annual stress tests. Thus, in March 2012, the Federal Reserve conducted financial stress tests on 19 of the largest banks in order to observe how each would fare under conditions of severe economic stress, with double-digit unemployment and with an even greater collapse in housing prices. Of the 19 banks, 15 passed the tests and were allowed to pay dividends and to acquire their own treasury shares.

The Dodd-Frank Act has called upon the U.S. Commodity Futures Trading Commission (CFTC) and the SEC to develop rules for derivative clearinghouse exchanges, but those rules would only handle standardized contracts (e.g., fritures contracts) and not customized financial instruments. Although the CFTC has proposed such regulations, bank lobbyists and some members of Congress have attempted to thwart them. Mandating margin requirements and collateral requirements for new derivatives contracts - regardless of whether they are standardized - could avert a future financial crisis. In fact, former Citibank advisor Robert E. Rubin, who has been severely criticized for his role in the global financial crisis, has since called for such margin requirements and additional capital requirements for parties issuing derivatives (Rubin, testimony before the Financial Crisis Inquiry Commission, Apr. 8, 2010, http://fcic-static.law.stanford.edu/cdn_media/fcic-testimony/20 1 00408-Rubin.pdf).

Since the financial crisis, a group of major banks - including JPMorgan Chase, Goldman Sachs, Morgan Stanley, Deutsche Bank, UBS, Credit Suisse, and Citigroup - has governed customized derivatives trading by making its own rules (Louise Story, "A Secretive Banking Elite Rules Trading in Derivatives," New York Times, Dec. 1 1 , 2010). Moreover, it was recently revealed that the London-based Barclays, along with other major banks, had been manipulating its forecasted interbank borrowing rates for some time; this affected the London Interbank Offered Rate (Libor) daily average, which serves as the basis for numerous financial transactions and derivatives worldwide. As a result, a new approach for developing a benchmark interest rate will be devised, under which major banks will have to document their borrowing rates. Indeed, there is a compelling need for global practice and ethics standards that apply to derivative clearinghouses and benchmark interest rates.

Although a new Financial Stability Oversight Council (FSOC) - composed of federal regulatory agencies, all of which failed to recognize the global financial crisis - has been formed, it is unclear what authority this council has with respect to wayward banks. Can the council actually manage such banks, or can the banks only be monitored by their own regulatory agency? In order to deal with the notion of "too big to fail," the FSOC has to decide which banks and nonbanks to monitor for systemic sensitivity.

Lastly, the aforementioned Volcker rule, which calls for banks to refrain from using their own proprietary funds in trading endeavors, has yet to be implemented. There is concern about what constitutes such funds or whether a bank could violate this rule by creating a market for particular securities to sell to other parties. Moreover, there is apprehension that banks having to abide by this rule will be uncompetitive in the international marketplace and will instead take their business abroad. Some members of the Senate and House are calling for a cost-benefit analysis of the Dodd-Frank Act.

Now that JPMorgan Chase has suffered at least a $5.8 billion loss from what it claims to be "hedging" with an index of CDSs, it is likely that the Volcker rule and financial reform will have a new lease on life; however, this rule will likely require clarification to distinguish between proprietary trading with FDICinsured deposits at stake and hedging to protect an overall portfolio of financial assets.

Accounting Consequences

The accounting profession received its share of blame for the financial crisis, specifically with respect to the subject of capital maintenance. In Statement of Financial Accounting Standard (SFAS) 157, FanValue Measurements, FASB required the fair valuation of financial assets, including loans and securities, at their actual market values, whenever feasible. When holding gains were reflected on those assets, the banking community did not complain. When losses began to mushroom due to fair value, banks and their lobbyists persuaded members of Congress to insist that FASB modify its standard to allow hypothetical values for these securities, for which there was no practical market FASB was compelled to relent; under pressure from Congress, it passed FASB Staff Position (FSP) FAS 157-4, Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly.

Effective in 2009, FSP FAS 157-4 offered additional guidance on valuation during illiquid market conditions, which are characterized by few transactions, large bid-ask spreads, and widely variant prices. In such circumstances, fair values can be adjusted to Level 3, a mark-tomodel approach, instead of applying specific prices from the market. In addition, FASB called for reporting on a quarterly basis instead of an annual basis, as well as for greater disclosure underlying such measurement, ranging from the specific fair value approaches used and the sensitivity of Level 3 measurements to changes in the inputs underlying the models.

The application of SFAS 1 66, Accounting for Transfers of Financial Assets, and SFAS 167, Amendments to FASB Interpretation No. 46(R), which started in 2010, should lead to higher capital maintenance reserves for financial institutions securitizing their assets with special-purpose entities, also called variable interest entities (VIE). The financial institution that acts as the primary beneficiary of the VIE now has to evaluate - based largely on qualitative factors reflecting which party bears most of the risks and benefits from the VIE - whether to consolidate that entity. It is important to note that, during the financial crisis, companies managed to avoid consolidation of VIEs if they did not quantitatively bear the majority of risks and rewards from those entities.

Furthermore, asset securitizations are now much more likely to be treated as secured borrowings, rather than as sales; such secured borrowings retain the loans along with the debt on the company balance sheet. The application of SFAS 166 and SFAS 167 should provide a more realistic reporting of debt on the balance sheets of financial institutions (John W. Briggs and Joseph D. Beams, "Asset Securitization in a Changing Environment," The CPA Journal, September 2012, pp. 64-67).

FASB and the IASB are working on a revised exposure draft on leasing, which is expected to put all long-term leases on the balance sheet as long-term assets and longterm debt The joint exposure draft is expected to be issued by the end of the first quater of 2013. In addition, FASB is developing a new standard to reflect impairment losses on financial instruments in a timely fashion.

In December 2012, FASB issued its exposure draft, "Accounting for Credit Losses on Financial Assets," which called for timely recognition of expected credit losses and disclosure of changing expectations. This proposed standard would require management to estimate cash flows that are not expected to be received from financial assets, based on both historical and forecast information. The balance sheet will show an up-to-date expected credit loss allowance; the income statement will show the decline or improvement in the expected credit loss during the period.

Lessons Learned

The author believes that several lessons can be drawn from the recent global financial crisis. Banks must not be allowed to become too big to fail and should not engage in proprietary trading, which induces volatility and risks FDIC depositors' funds. When lending and managing their loans and investments, banks should place an emphasis on safety in order to protect depositors. Banks need liquidity, which is difficult to achieve if they utilize excessively risky investments; strict regulatory capital maintenance rules are imperative to promote liquidity. If banks are overly leveraged, they need to be especially concerned with maintaining a liquid investment portfolio. Although banks should be permitted to take risks based on due diligence, the government should not, in this author's opinion, bail them out if these risks go south. As under the Dodd-Frank Act, annual or semiannual stress testing of the capital structure of banks, including key financial ratios, is a necessity.

In addition, bonuses to bank managers should emphasize the long-term goals of an institution, with mandatory clawbacks if these managers succeed only in the short term. This would avoid the moral hazard of current payments given to executives whose performance becomes dysfunctional over time. For example, JPMorgan Chase intends to institute such clawbacks against the managers involved in its recent loss on credit derivatives.

A key aspect of the financial crisis was the failure of banks and other financial institutions to maintain an adequate equity cushion to protect creditors from risk. This is known as capital maintenance - that is, the ability of an enterprise to keep enough capital or stockholders' equity (net assets or wealth) to shield creditors, who have priority over stockholders in the event of liquidation, from losses that have occurred due to declines in the fair valuation of loans, securities, and other financial assets. Too many financial institutions have been excessively leveraged and, as a consequence, have been subject to margin calls from creditors on their debtfinanced assets or have become insolvent. It should stand to reason that if a financial institution engages in risky asset acquisitions, it should maintain adequate capital reserves to protect its creditors and to guard against bankruptcy; however, this has not been the case domestically or globally. Raising such reserves on an international basis is necessary to prevent regulatory arbitrage from country to country.

Three former SEC chairmen have observed:

During times of financial distress, there is always pressure to change accounting standards in order to inflate the value of assets. . . . Banking regulators can ease such stresses by reducing regulatory capital requirements (Roderick M. Hills, Harvey L. Pitt, and David S. Ruder, "Don't Let Banks Hide Bad Assets," Wall Street Journal, Nov. 18, 2009).

To the extent that capital reserve requirements differ among accounting, finance, and banking, disclosure of such differences should be imperative in annual financial reports of banks and other financial institutions for the benefit of their stakeholders. Additional disclosures should reflect the particular bank regulation capital reserve requirements (e.g., under applicable Basel I, II, or ??) to the institution. Furthermore, initial and maintenance margin call requirements for risky assets in a leveraged position should be stipulated. Financial institutions issuing customized derivatives should also provide some disclosure pertaining to the adequacy of capital reserves; however, bank regulators have a different mindset from accounting and financial regulators because they believe that "transparency may not always be the best way to prevent a run on the bank" Report of the Financial Crisis Advisory Group, Jul. 28, 2009).

Another necessity is more extensive disclosures by banks; in particular, a reconciliation of bank regulation requirements and GAAP in financial reporting should be provided in annual reports. Based on the events before, during, and after the global financial crisis, it is clear that financial statements of banks have conveyed lessIhan-full disclosure. This leaves individuals wondering what specific risks are currently included in their loan and investment portfolios. JPMorgan Chase, in particular, has yet to be transparent about the nature of its significant losses.

To the extent that banks now have actively engaged boards of directors and audit committees, enterprise risk management might be under control, and catastrophic effects from derivatives might be averted in the future. Otherwise, stockholders should be responsible for reining in management behavior. From an accounting standpoint, asset impairments were too few and too late during the global financial crisis; accordingly, FASB is working on a revised impairments standard to apprise financial statement users of anticipated losses in a timely fashion.

Additional Concerns

It has been more than three years since the global financial crisis and more than two years since the passage of the DoddFrank Act, but much remains to be done to reform the financial industry. In particular, a gray area exists between hedging and speculating. Accordingly, due diligence in the selection, application, and management of derivatives is a must. There are still far too many opaque derivative transactions, which represent a time bomb waiting to explode.

In the aftermath of the global financial crisis, the federal government was more concerned about bailing out the "big fish" (i.e., the banks) than with rescuing the "small fry" (i.e., the embattled mortgaged home owners). In this author's opinion, government bailouts of banks should be a thing of the past.

Furthermore, the CFTC has recently defined "swaps" in a 600-page report, illustrating the complexity of the Dodd-Frank Act A new Consumer Financial Protection Agency is dealing with deceptive practices in the issuance and administration of mortgages, consumer loans, and student loans. But as the latest controversy concerning the manipulation of the Libor benchmark interest rate shows, banks have a long way to go in order to secure consumers' trust

Robert Bloom, PhD, is a professor of accountancy in the ? oler School of Business at John Carroll University, University Heights, Ohio.