Book Value vs Market Value
Traditionally, banks used accrual accounting for essentially all their assets and liabilities. They would take on liabilities, & they would invest the proceeds from these liabilities in assets. All assets and liabilities were held at book value. Doing so, disguised possible risks arising from how the assets and liabilities were structured.
An Example
Consider a bank that borrows USD 100 millions 3.00% for a year and lends the same money at 3.20% to a highly rated borrower for 5 years. For simplicity, assume interest rates are annually compounded and all interest accumulates to the maturity of the respective obligations. The net transaction appears profitable as the bank is earning a 20 basis point spread.
This is shown as below:
The book value of the loan (the bank’s asset) is:
USD100m*(1.032) = USD103.2m (USD100m+USD3.2m) (including interest income USD3.2million) [1]
The book value of the financing (the bank’s liability) is:
USD100m*(1.030) = USD103.0m (including interest expense USD3.0m) [2]
Based upon accrual accounting, the bank earned USD200,000 in the first year.
The Hidden Risk
At the end of a year, the bank will have to find new financing for the loan, which will have 4 more years before it matures. If interest rates have risen, the bank may have to pay a higher rate of interest on the new financing than the fixed 3.20 it is earning on its loan. Suppose, at the end of a year, an applicable 4-year interest rate is 6.00%. The bank is in serious trouble. It will be earning 3.20% on its loan and paying 6.00% on its financing. Accrual accounting does not recognize the problem. Market value accounting recognizes the bank’s predicament in the following way. The respective market values of the bank’s asset and liability are:
USD100m*(1.032)^5
————————— = USD92.72m [3]
(1.060)^4
USD100m*(1.030) = USD103.0m [4]
- Equation 3 is Future Value of the loan one year from now. This is arrived at by discounting the future value of the loan at the end of 5 year to the value at the year-end 1.
- Equation 4 is the future one-year value of the current borrowing.
The problem in this example was caused by a mismatch between assets and liabilities. Prior to the 1970’s, such mismatches tended not to be a significant problem. Interest rates in developed countries experienced only modest fluctuations, so losses due to asset-liability mismatches were small or trivial. Many firms intentionally mismatched their balance sheets. Because yield curves were generally upward sloping, banks could earn a spread by borrowing short and lending long.We see from the above 2 equations, that from a market-value accounting standpoint, the bank has lost USD10.28m. Thus we see that the market value accounting offers a better portrayal of the banks’ position. The bank is in trouble, and the market-value loss reflects this. Ultimately, accrual accounting will also recognize a similar loss. It will accrue this as yet unrecognized loss over the 4 remaining years of the position.
Things started to change in the 1970s, which ushered in a period of volatile interest rates that continued into the early 1980s. Managers of many firms, who were accustomed to thinking in terms of accrual accounting, were slow to recognize the emerging risk. Some firms suffered staggering losses. Because the firms used accrual accounting, the result was not so much bankruptcies as crippled balance sheets. Firms gradually accrued the losses over the subsequent 5 or 10 years. Increasingly, managers of financial firms focused on asset-liability risk. The problem was not that the value of assets might fall or that the value of liabilities might rise. It was that capital might be depleted if the value of assets and liabilities might fail to move in tandem.
Asset-liability risk is thus a leveraged form of risk. The capital of most banks is small relative to the banks assets or liabilities, so small percentage changes in assets or liabilities can translate into large percentage changes in capital. Accrual accounting could disguise the problem by deferring losses into the future, but it could not solve the problem. Banks responded by forming asset-liability management (ALM) departments to assess asset-liability risk. They established ALCO committees comprised of senior managers to address the risk. The understanding of book value vs market value is crucial to understand the importance of ALM and ALCO. Hope you got a good idea of how accrual accounting disguises some of the liquidity problems a bank may face. Kindly share your thoughts and feedback.
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