Yesterday, Fed Chairman Ben Bernanke gave a major speech on Financial Reform to Address Systemic Risk. That speech signaled his desire to start the process of reform:
At the same time that we are addressing such immediate challenges, it is not too soon for policymakers to begin thinking about the reforms to the financial architecture, broadly conceived, that could help prevent a similar crisis from developing in the future. We must have a strategy that regulates the financial system as a whole, in a holistic way, not just its individual components. In particular, strong and effective regulation and supervision of banking institutions, although necessary for reducing systemic risk, are not sufficient by themselves to achieve this aim.
Today, I would like to talk about four key elements of such a strategy. First, we must address the problem of financial institutions that are deemed too big--or perhaps too interconnected--to fail. Second, we must strengthen what I will call the financial infrastructure--the systems, rules, and conventions that govern trading, payment, clearing, and settlement in financial markets--to ensure that it will perform well under stress. Third, we should review regulatory policies and accounting rules to ensure that they do not induce excessive procyclicality--that is, do not overly magnify the ups and downs in the financial system and the economy. Finally, we should consider whether the creation of an authority specifically charged with monitoring and addressing systemic risks would help protect the system from financial crises like the one we are currently experiencing.
As part of those efforts, however, let me add one more element: we must proactively deal with the issue of intangible assets. Intangibles are a major part of the wealth and the wealth generating capacities of companies and nations. To continue a financial system that simply ignores them is bordering on folly. Here are some suggestions, based on our report Intangible Asset Monetization: The Promise and the Reality. (See also our article in IAM Magazine "Building a Capital Market for Intangibles.")
Let me start with the issue of asset valuation - a key concern for intangibles. It should be noted that Bernanke specifically mentioned this problem in the context of accounting standard for valuing bank reserves. However, as the New York Times notes, "In a question-and-answer session after the speech, Mr. Bernanke said he did not favor a suspension of the mark-to-market accounting standards, but said that the weakness in current rules should be identified and corrected." I agree that a simply suspension of mark-to-market is unwarranted, and I believe would be counterproductive. Here I have to disagree with Steven Pearlstein who, in his column today, shifted his position and called for such a suspension.
The underlying issue is how to value assets that have only thinly traded market. As Bernanke said, "determining appropriate valuation methods for illiquid or idiosyncratic assets can be very difficult, to put it mildly." Yet, it is exactly the problem of appropriate valuation methods that we must address.
The truth is that accountants have been valuing "idiosyncratic assets", in the form of intangibles, for a long time - mostly for the purpose of M&A transactions and lawsuits. In fact, current account rules require than intangibles acquired from outside (such as in a merger or acquisition) be placed on the books.
One way to begin to get a handle on the valuation issue is to re-instate the joint FASB/IASB project on valuing internally generated intangibles - as well as externally acquired as under current rules. Such a project would have to grapple with the valuation problem head on. This project has had an on-again, off-again history for over a decade. It is time to just do it.
Another is to ratchet up other venues for research on valuation standards. The International Valuation Standards Council has two draft guidance notes on valuing intangibles (see earlier posting). These could serve as the starting point for more intensive research.
But the problem is not just valuation. The larger problem is disclosure. Increased transparency is needed. In fact, in some cases, simple disclosure may be enough - with out having to take the next step of valuation. A large part of the problem with the toxic assets is their uncertainty and complexity. And a large part of the liquidity and solvency issues of financial institutions stemmed from that uncertainty and lack of transparency.
The same can be said of intangibles. There is a lack of transparency - to the point of having a situation that company management doesn't even know what their intangible assets are. If the details of the intangible assets are disclosed, then each individual in the market can deal with the valuation in their own way. And if the market demanded greater disclosure, management would focus more attention on managing those assets better.
Two quick suggestions on improving disclosure of intangible assets. First, the SEC could expand the disclosure of intangible in the Management's Discussion and Analysis (MD&A) statement required as part of annual corporate filings. In 2003, SEC issued new guidance on including non-financial performance measures in the MD&A statements. SEC should undertake an evaluation of compliance with that guidance and, based on that evaluation, issue expanded guidance specifically on the disclosure of intangible assets.
Second, SEC should look seriously at creating a "safe-harbor" provision to allow for limited reporting of non-standardized financial information on intangibles. As noted before, current accounting rules limit the ability of companies to disclose financial information on internally generated intangibles - specifically limiting information that does not comply with Generally Accepted Accounting Practices (GAAP).
There are good reasons to limit such information. The purpose of GAAP is to ensure that the assumptions and rules used to compile financial information are understood by all. There is a real danger of non-GAAP information resulting in misleading financial statements.
However, it has long been recognized that some financial information not covered by GAAP can also be useful and relevant to investors. As a recent white paper by the AICPA Assurance Services Executive Committee notes:
In order for efforts to improve reporting and assurance to reach fruition, there is a need for improved safe-harbor legislation to protect directors, managers, and auditors who make a good faith effort to provide more high quality, transparent disclosures.
Such a safe harbor would allow companies to provide information, including estimates of value, on their IP portfolios, for example. Such overt disclosures would enable more accurate insight for investors and creditors alike while also promoting the above-the-board reputation of company management.
It will take some work to craft a safe harbor provision that facilitates greater disclosure while not undermining the regulatory purpose of avoiding misleading information. But it is a task that SEC can and should undertake.
So, as we move toward reforming the regulatory structure around the financial system, let us not forget about intangibles. There are a number of relatively easy steps (easy compared to some of the more challenging tasks facing financial reform efforts) that can be taken to increase disclosure of intangible assets. Those steps would both increase transparency in the system and foster greater understanding and utilization of intangibles. That would be a classic win-win.
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