Financial analyst

Economic Value versus Reported Book Value

Economic value represents the net market value of the assets and liabilities at a moment in time. It represents the value if the assets were sold and used to buy back its liabilities assuming that their sale and repurchase have no direct impact on market prices:
Economic value = Market value of assets ? Market value of liabilities Economic value is very different from the accounting-based definition of value, where reported
shareholders’ funds are given by:
Shareholder funds = Book value of assets ? Book value of liabilities
Under the accounting version a bank’s value remains unchanged whether rates rise or fall. There are three methods that may be used to account for securities holdings. In some
countries all three methods are used depending on the security’s classification:
Carried at cost. Under this method the value of the security on the books is left unchanged at the acquisition price. In a rising interest rate environment this will result in a reported book value that is greater than a bank’s economic value. Marked-to-market – income statement. Under this method the security is revalued at the current market price. Any unrealized gain or loss is taken through the income statement. Marked-to-market – balance sheet treatment. The security is again revalued at current market price. The unrealized gain or loss is not, however, taken through the income statement but is reflected in an additional account within shareholders’ fund. This account is usually called something like “Reserve for unrealized gains or losses on securities”. The loss or gain is only taken through the income statement when realized.
Accountants employed by banks, regulatory bodies or working for standards bodies have an ongoing tussle over whether, and how, to make bank accounting policies provide a realistic picture of the underlying economic value. Banks have by and large resisted moves towards market-based valuations on the grounds that this would make their reported earnings increasingly volatile and that it is difficult to determine a market price for many of their loans.
The result has been, and is likely to continue to be, an uneasy compromise that accepts implicitly that published bank accounts do not provide an accurate measure of economic value. This compromise involves the acceptance of a number of internal inconsistencies.
An example of this inconsistency would be at a bank that has both fixed rate mortgages and fixed rate bonds. There will be a negative impact on the economic value of both the mortgage loans and the bonds if interest rates rise.
In most countries banks are required to recognize the fall in the value of the bonds but will not have to recognize the fall in the value of the fixed rate mortgages.
One of the problems associated with not “marking to market” all investments is that it can provide an incentive for banks to sell investments that have a market value above their book value while retaining other instruments on which the bank has a paper loss. This will result in a book value that is inflated relative to its economic value and artificially inflate reported earnings.