The application of IAS 39 under distressed market conditions : a local case study

Abstract

The provisions of IAS 39 on mark-to-market accounting have recently come under the spotlight as a result of the turmoil which hit money markets in late 2007, and which is still ongoing. Questions arose about the suitability of valuing assets at market prices at a time when credit markets were clearly distressed and dysfunctional. Critics also argued that marking-to-market has a procyclical impact, which has contributed towards deepening the credit crisis. Banks' assets are marked down in a recessionary situation, as perceived credit risk rises. This depresses banks' capital base and capacity for further lending, thereby aggravating the downturn. On the other hand, accentuated increases in bank profits and capital during upturns could support the overextension of credit. This study analyses how the severe downturn in market prices affected the profitability and capital adequacy of a major local Bank, and how this institution reacted to the situation. It also attempts to quantify what the effect on the Capital Adequacy ratio would have been had the Bank not resorted to alternative asset valuation techniques. Other consequences of the downturn, primarily its effect on the Bank's dividend distribution policy, are also investigated. The study makes extensive use of financial information disclosed by the Bank, and of interviews with top finance and risk management executives. The study concludes by showing that, contrary to public perception, the vulnerability of local Banks to volatility in international money markets can be material, and may impact the local financial sector's ability to extend credit to the Maltese economy.