3. Regulatory Markers for Stable Financial Market Structures MANAGERKREIS DER FRIEDRICH-EBERT-STIFTUNG 3.1 Dealing with the systemic importance of rating agencies The rating agencies played a big role in fuelling the boom in subprime securities and thus ultimately also the U.S. housing bubble. Over many years they drastically underestimated the risks of securitised products. This was an outcome not only of inadequate valuation models, but also of distorted incentives: the agencies profited more from giving positive ratings than from negative ones. It is also worrying that the oligopolistic market structure has led to a synchronisation of risk assessment by just a few firms. Here, in the absence of pluralism, there are dangers produced by herding, as well as a risk of market manipulation. Due to the importance of the stability of the financial markets, rating agencies need to be subjected to effective supervision. The first step at the European level has been taken, with legislation for regulating the rating agencies passed in mid-2009 by the European Parliament and the EU Council. It remains to be seen whether the goals pursued by the decree will be achieved. 3.2 Accounting It was already apparent at an early stage in the financial crisis that market value accounting considerably exacerbated the problems by forcing fire sales. Accounting on the basis of fair value leaves bank balance sheets extremely vulnerable to price fluctuations in the corresponding financial markets. When listed asset prices collapsed, the banks’ balance sheets imploded immediately. The write-offs required by falling prices eroded the banks’ equity and forced them into emergency sales – which further worsened the drop in the markets. In times of boom, conversely, market value accounting generates exaggerated profits when asset prices rise across the board, leading to an excessive expansion of dividend and bonus payments. From a theoretical standpoint the existing rules can be criticised for focusing too strongly on the perspective of the individual economic actor and ignoring systemic implications. Another point is that the fair value principle implies that market value is always the same as true value. But such perfect information efficiency does not exist in reality. Instead price bubbles and market corrections flow directly into bank balance sheets. So accounting purely according to current market prices generates extreme fluctuations in recorded profits while failing to draw a realistic picture of the long-term prospects. This inherent pro-cyclical bias in fair value accounting thus amplifies the systemic risk in the banking sector not inconsiderably. What we need are accounting rules that are designed for a long-term perspective extending over the whole economic cycle. The primary purpose of accounting is to draw the most reliable possible picture of financial status and profitability. Market value accounting has been found to be largely inadequate to that task. It is questionable whether the current“Expert Group on Accounting Rules” possesses sufficient democratic legitimisation; accounting arrangements are much more than a mere technicality. Thus the whole approach of market value accounting and the institutional methods by which rules are set must be fundamentally reconsidered. 7