Scholes: Bring Transparency to Banks’ Illiquid Assets

On Tuesday, Nobel Prize winning economist Myron Scholes asserted that banks should provide fair value estimates for their illiquid assets. To do so, he urged that banks shift more of their illiquid assets to exchanges and expand mark-to-market accounting. Currently, the Financial Accounting Standards Board is considering whether to expand its fair-value rules to bank loans.

If implemented, Scholes’ recommendation would constitute an important step toward greater transparency, more timely reporting, and more credible information. In theory, armed with improved assessments of the value of a financial institution’s assets, investors would be able to make better capital allocation decisions. In turn, better capital allocation decision making should lead to improved macroeconomic outcomes over the long-run.

In his book, The Roaring Nineties (W. W. Norton & Company, 2003), Columbia University economics professor Joseph Stiglitz explained the linkage between capital allocation and macroeconomic outcomes as follows:

When share prices reflect bad information, resources are likely to be badly deployed. In the late nineties, they were very badly deployed. Rising prices say, “invest more.” The fast-rising prices of tech and telecommunications stocks led to an enormous overhang of investment in those sectors of the economy. That overhang, in turn, was partly responsible for the long downturn that began in late 2000. And it all started with ill-advised accounting practices…

For a market economy to function well, all the participants must have confidence in it. Investors and potential investors need to believe that there is a level playing field, with accurate information, rather than a rigged game in which insiders are bound to win.

Additional measures that could reduce the problem of asymmetric information—information that is not possessed at the same time by all market participants—would include:

• Expensing of stock options. Ultimately, stock options have a dilutive impact on shareholder wealth. Expensing would allow shareholders to better assess the costs and benefits of such options.

• A dramatic reduction of off-balance sheet items. The practice of shifting potentially significant items off the balance sheet tends to make it more difficult for investors to reasonably assess the risk associated with a given firm. With such items having no visible impact on the net worth of a company, management could also be more willing to take larger risks than if the items were reported on the balance sheet.

• A robust strengthening of the conservatism constraint. In other words, when the value of a balance sheet or income statement item is difficult to determine, the firm should adopt the practice that is least likely to overstate income or asset valuations.

• Full disclosure of investment positions. Such disclosure would entail providing gross positions, in addition to netting them out. Henry Kaufman, one of the nation’s leading private sector economists explained in his On Money And Markets: A Wall Street Memoir (McGraw-Hill, 2000), “At times of turmoil, market participants can’t rely on netting plus positions and minus positions with clients. Thus, gross exposures may be the true exposures.”

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