Tom Kenny, chair of the Equity Release Working Party, Staple Inn 28 February 2019
… I would say what hasn’t come out of the paper is what the difference between those two approaches [i.e. Real World and Risk Neutral] is, and that’s something the working party wants to look at, to say .. what is the difference between the two approaches, and then have that policy debate, because, you know, market consistency is obviously where we are today in a large part of the financial industry, but market consistency doesn’t necessarily work. [The] global financial crisis was largely driven by the investment banks and the banking approach to modelling risk and that’s purely a market consistent approach.
Kenny’s claim is strange on a number of levels. Hans Hoogervorst, Chair of the International Accounting Standards Board, has this to say about the relation between IFRS and the Crisis.
Some critics of International Financial Reporting Standards argue that they gave an overly rosy picture of banks’ balance sheets before the crisis and are still not prudent enough despite improvements since then. These same critics also argue that excessive reliance on fair value accounting, which reflects an asset’s current market value, has encouraged untimely recognition of unrealised profits … The British bank HBOS, which collapsed and was taken over by Lloyds Banking Group during the crisis, has been presented as an example of failing pre-crisis accounting standards. The truth is that HBOS met bank regulators’ capital requirements, and its financial statements clearly showed that its balance sheet was supported by no more than 3.3 per cent of equity. For investors who cared to look, the IFRS standards did a quite decent job of making crystal clear that many banks had wafer-thin capital levels and were accidents waiting to happen.’ (Financial Times,
That’s right. Regulatory approaches to banking capital management use the weird ‘Risk Weighted Assets’ method where the market value of the asset is weighted according to its presumed risk. Supposedly low risk assets like residential mortgages are given a low weight, so the imputed asset size appears much smaller than the market consistent valuation. Yet Kenny refers to ‘the banking approach to modelling risk’, which is the RWA method, so appears to have confused risk weighted asset valuation with market consistent asset valuation. Easy enough I suppose.
As for the causes of the crisis, that’s a bit of a rabbit hole, but Kenny’s suggestion that ‘real world’ valuation could have somehow have averted the crisis is totally strange, and the exact opposite of the truth.
One explanation for the crisis is that housing markets tend to overshoot both upwards and downwards. They go up for a long period in a way that is inconsistent with fundamentals, then go down for an equally long period. See the chart above showing how Detroit house prices are rising throughout a period where the population has been falling, then fall again for reasons that have to be totally unconnected with fundamentals like population, supply and demand etc.
When the market overshoots upwards, mortgage loans from banks increase, keeping the odd 3% sliver of equity. When eventually the market turns downwards, it keeps going, cutting through the wafer of equity, bad things happen etc.
Now that’s when assets are valued on a market consistent basis. The fault is not the market consistency, but rather how that the risk weighting, the ‘banking approach to modelling risk’ disguises the ultra-thin levels of capital. But Kenny wants us to go one step further into the plague pit. So called ‘real world’ valuation assumes (i) that the upward trend will continue indefinitely (say at Just’s 4.25% HP assumption) and (ii) that we can present value the asset as though the forecast trend were absolutely certain.
Using such a valuation technique, we are exposed not just to a fall in asset value, but also to the failure of the future growth forecast to be realised.
What kind of crisis might that cause?