SPEAKERS CONTENTS INSERTS
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FINANCIAL ACCOUNTING STANDARDS
BOARD'S RULE
WEDNESDAY, OCTOBER 1, 1997
House of Representatives,
Subcommittee on Capital Markets, Securities
and Government Sponsored Enterprises,
Committee on Banking and Financial Services,
Washington, DC.
The subcommittee met, pursuant to call, at 10:05 a.m., in room 2128, Rayburn House Office Building, Hon. Richard H. Baker, [chairman of the subcommittee], presiding.
Present: Chairman Baker; Representatives Lucas, Snowbarger, Lazio, Bachus, Campbell, Kanjorski, Gutierrez and Vento.
Chairman BAKER. I would like to call this hearing of the Capital Markets Subcommittee to order.
To proceed, I am understanding that there are Members on their way to participate. I have a brief opening statement that I will summarize to save us some time. I am understanding the House may, in fact, adjourn at midday today, and I am hopeful that Members will be here before they begin to depart for home. I am hopeful we can move along expeditiously.
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Let me first say that I appreciate Mr. Jenkins' willingness to participate in the hearing this morning, and from the early days of consideration of the proposed regulation to the current moment, there has been an extensive effort made by FASB, and I think accommodations modifications, suggested by market participants have reshaped the rule. And to a great extent, progress has been made.
However, the reason for the hearing this morning is with regard to principally the largest end-users of derivatives, financial institutions, and this subcommittee's interest in understanding the consequences of those regulations on that industry.
I think it is important to say what this hearing is not about. It is not about Congress prescribing accounting standards for reporting by financial institutions or any other business. It is not about a political interference in an administrative process. And it is most certainly not about attempting to hide important information from investors or customers of a bank as to the financial stability of that institution.
The hearing is really about consequences, the consequences of a regulatory agency prescribing rules that will change the ways in which financial institutions report their true financial pictures. It is to ensure that the public, investors and customers of the banking organizations have the best possible information with which to make informed decisions.
It is my intention, as well as current technology will permit, to provide total transparency in the disclosure of financial conditions. Unfortunately, I am worried that the current recommendation may actually cloud the view for interested third parties, and that is unfortunate, because I believe all parties are in pursuit of a common goal.
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In the course of the hearing, we will not only hear from FASB and the SEC, we will also hear from the Federal Reserve as to their concerns. This is not a simplistic, casual political inquiry into the serious business of regulating risk of financial institutions, but hopefully will be a careful analysis based on the concerns of other Federal financial regulators.
We will also hear from industry participants. It is clear to me that proponents of the new regulations have made unusual efforts to influence participants in the market to accept the new rules, even before the final rules have been promulgated. For whatever reason, this issue has taken on some dramatic elements, surprisingly to me, with advocates claiming precarious consequences if the plan is not ultimately implemented.
I find that interesting, in light of my belief that this whole process truly had its origins in congressional prompting. I also find it interesting there is a clear and marked difference of opinion as to the consequences of these proposed regulations, even among international regulators.
David Tweedle, Chairman of the United Kingdom's Accounting Standards Board, said, ''We don't like it, we don't accept secondhand standards. We in the U.K. are certainly not going to pick up this one.''
I make this observation to clear up misunderstandings that the intervention of this subcommittee is the result of some political complaint from a disgruntled market participant. There is a clear division of opinion as to the need and consequences of these proposals. Frankly, you have to question the logic of someone getting ready to jump on a seesaw and not looking to see if someone is on the other seat before they jump. With relation to derivative instruments, how fair is it in this process that you would not look at the asset or liability against which the derivative is intended to hedge?
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I do support accounting to fair market value and honest disclosure. It is absolutely clear the proposal centers on one bank product as opposed to the exclusion of all other assets or liabilities held at book value. If we are to move to the new standard, we should move for all bank products.
Now, I understand this proposal may be viewed as an incremental step toward the ultimate standard. I would suggest that jumping off a cliff is not a good incremental step toward bridging the chasm. My views have cemented a bit over the past 24 hours as the machinery of regulators has apparently been turned on and calls have been made to constituents relative to the accounting profession asking them to call Congressman Baker about the proposed hearing.
If you indeed wish to pursue professional review without political interference, we should at least refrain from political activism for our own benefit. As a result of today's hearing, it should be noted that Members certainly will make a determination about what, if any, further action may be necessary, but I am hopeful that the concerns that will be raised will be appropriately answered and that no further action of the subcommittee will be warranted.
With that, I recognize Mr. Vento.
Mr. VENTO. Well, thanks, Mr. Chairman. I don't know whose responsibility it is for this chocolate candy.
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Chairman BAKER. I was wondering. We have a candy at our desk. We don't know where it came from.
Mr. VENTO. It is Halloween arrived early, I guess.
Mr. Chairman, let me say, I have no prepared statement, but I want to commend you for calling the hearing and for the work you have done. I noted the comments that have been picked up in the media. This topic is not a new topic to Congress nor is it to the accountant group that has, in fact, set this forth. They have been working on it for, it looks to me like some seven years, and some further refinement of the rules and of their standards is in the offing in December.
I am concerned about it. I think it has such a significant impact on financial institutions which are responsible for, in fact, funding and intimately are involved in the derivatives, or what have become known as derivatives. It is an integral part of what we look at in terms of commercial banking. I mean, I can understand where the accountants would like to refine and define every increment of value with regard to mark-to-market, and the concerns that they have in terms of trying to articulate and monitor. But it seems to me that in the essence of it, the essence of derivatives is a very dynamic one, and trying to attach such value may, in fact, have a perverse effect in terms of the ability of our economy to function and for the conventional role, or the important roles that financial institutions play today in what have come to be defined as derivatives.
Aside from that, of course, I am hopeful that the Federal Reserve Board and the OTS and others, not just the Office of Thrift Supervision, but the Office of the Comptroller of the Currency are involved in this, because we need to hear from them. I am very concerned that we have behind this another action where you really fundamentally are changing, or asking the SEC to play a much more significant role as the Chairman has observed. I am sure that may not be the intent of the accountant standard that is provided, but that is what the effect of it is.
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We need to be aware of that particular change and phenomena, because inadvertently we may, in fact, really hamper the ability of the financial markets to deliver the type of capital and to function efficiently with this type of standard.
I know that I can just say from personal experience that since 1989, when the subcommittee moved mark-to-market all the real estate portfolios of, for instance, the thrifts, it had a major repercussion in terms of what happened with high yield bonds, if you recall, the junk bonds. There was a lot of concern about that, and even as we go back and look at it today, I think this is just one segment and one area which is much more narrowly defined, and it had a profound effect in terms of the value of those bonds. I don't think that was our intent at the time. We obviously wanted to dispose of them and to take the thrifts out of something we saw as being undue risk and try to stabilize what was then a serious problem in terms of the financial condition of many thrifts. But it had a different effect.
So we have had a little bit of experience with this, but we are looking forward to learning from the witnesses today and in the months ahead so we can obviously move and make this transition, if there is going to be a transition, smoothly, so that we do not disrupt the financial marketplace and the role that these banking institutions, play in this marketplace.
Thank you, Mr. Chairman.
Chairman BAKER. Thank you, Mr. Vento.
Mr. Snowbarger, you have no opening statement?
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Mr. SNOWBARGER. No.
Chairman BAKER. Mr. Bentsen.
Mr. BENTSEN. No.
Chairman BAKER. Mr. Gutierrez.
Mr. GUTIERREZ. No opening statement, thank you.
Chairman BAKER. I would like to recognize our first witness this morning, a gentleman of distinguished accounting experience, 38 years, the Chairman of the Financial Accounting Standards Board, Mr. Edmund Jenkins. Thank you, sir.
STATEMENT OF EDMUND L. JENKINS, CHAIRMAN, FINANCIAL ACCOUNTING STANDARDS BOARD
Mr. JENKINS. Thank you, Mr. Chairman and Members of this subcommittee. I am Edmund Jenkins, Chairman of the Financial Accounting Standards Board, and with me is Corliss Montesi, one of the project managers on the subject of today's hearing. We are pleased to be here today to discuss the role of the Financial Accounting Standards Board in the marketplace and our recent work on the issue of derivatives. I have brief prepared remarks, and, Mr. Chairman, I would like to have my full statement and supporting materials entered into the public record.
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Chairman BAKER. Without objection, and for the record, all witnesses' comments will be included in the record this morning. Thank you, sir.
Mr. VENTO. I would ask that Mr. Kanjorski's opening statement and opening statements of Members be put in the record as well.
Chairman BAKER. Without objection.
Mr. VENTO. Thank you.
Mr. JENKINS. Let me begin by telling you a little about the FASB. We are an independent, private sector organization that is funded entirely by that private sector. Our mission is to set accounting and reporting standards to protect the consumers of financial information, most importantly, investors and creditors. Those consumers rely heavily on credible, concise, and understandable financial information for effective participation in the capital markets. The FASB attempts to ensure that financial reports give those consumers an informative picture of an entity's financial condition and activities, and do not color the image to influence behavior in any particular direction.
Our standards affect many organizations, not just banks and public companies, but also small businesses and nonprofit organizations. Our decisionmaking process has to be fair. We operate under rules of procedure that require an extensive due process that is open to public observation and participation. That due process was modeled on the Federal Administrative Procedure Act, but is broader and more open in several ways.
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In our derivatives and hedging projects, we have gone well beyond even that extensive due process. For example, we have given our constituents five opportunities to provide comments, even though our rules of procedure require only one. We have done that because we wanted to consider carefully the views of all of our constituents, including issuers and auditors of financial information.
Those views are all important, but ultimately, the value of accounting and reporting standards is determined by how useful the information will be to investors and creditors. To protect the consumers of financial information, which include millions of small individual investors who are the backbone of our economy, we must avoid placing the interests of any particular group over the consumers' interests.
What the proposed standard on derivatives is all about is the public's right to know. Consumers have demanded more information about derivatives and hedging. A recent editorial in Pensions & Investments said, ''If ever a case can be made for reporting something in more detail, it is for derivatives.''
The Association for Investment, Management and Research, which is an organization representing investment analysts, portfolio managers, and other investment decisionmakers, told us in a letter that, ''accounting for derivative instruments and hedging activities remains a significant deficiency in current accounting standards.''
The results of the deficiency are well documented. Several times over the past few years, investors and creditors have been surprised by large unexpected losses by entities that did not report their derivative activities in an informative way. Taxpayers, too, have been adversely affected as the situation in Orange County, California, has amply demonstrated.
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In fact, a few years ago, Congress was considering a ban on certain types of derivative activities because of those spectacular losses. Instead, Congress, the SEC and others, urged the FASB to accelerate its project and develop standards for derivative and hedging activities as quickly as possible.
The FASB started working on the derivatives and hedging project in 1991. In June 1996, after 100 public meetings on derivatives and hedging, we published an exposure draft of our proposed rules. Our constituents sent us literally hundreds of letters commenting on the exposure draft. We spent another 23 meetings, including a 4-day public hearing, considering those comments and making changes to our proposal.
We now are in the final stages of our work on an accounting standard for derivative instruments and hedging activities. In August of this year, we circulated widely our proposed standard for comment by October 14. We expect to complete our work and issue a final standard in December 1997. To allow time for enterprises to understand and apply the standard, requirements will not be effective until calendar year 1999.
The underlying cause of the problems we are trying to correct is that there are no specific reporting standards for many types of derivatives and hedging activities in use today. As a result, current reporting practices often do not help a consumer understand a company's derivative and hedging activities or compare those activities to similar activities of another company.
For example, different companies may report very similar activities differently, and even an individual company may report similar activities differently.
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Many entities do not report some or all of their open derivative positions in financial statements.
Gains and losses on derivatives used to hedge risk often are reported as liabilities and assets rather than as income or expense in an income statement. Reporting an actual loss as an asset is simply wrong.
Our proposal is intended to correct those problems. As I said, we received hundreds of comments on our 1996 exposure draft, nearly 500. We accepted most of the recommendations that we heard most frequently, especially those from financial institutions, and we changed many of the detailed requirements as a result.
Our proposed standard retains more of the best features of existing reporting practices, and earnings will be much less volatile than under the exposure draft, but we did retain two aspects of the proposal in the exposure draft that we thought were the most important: All derivatives will be reported on balance sheets at fair value, and losses and gains on derivatives will not be reported as assets and liabilities. In our view, these are the essential elements of the public's right to know and to make informed investment decisions.
A derivative is an asset or liability. The derivative obligates one party to give up something of value, usually cash, at some time in the future. I am sure you understand that, from a simple accounting point of view, an obligation like that is a liability. Similarly, the right to receive cash is an asset, in the same way that a bank's right to receive payments on a loan is an asset. Fair value is the best measure of those assets and liabilities because fair value represents the amount of cash that the parties are entitled to receive or are obligated to pay. Investors and creditors need to know about those assets and liabilities to make good decisions.
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Some have suggested that derivatives do not need to be reported in the financial statements at fair value. They have said that disclosing fair value information in notes to the financial statements would be sufficient. We do not agree. Information is harder to find back in the notes, and it would leave investors and creditors wondering which set of information to believe, what is in the financial statements or what is in the notes. More important, gains and losses are not explicitly disclosed today, and their effect on earnings is difficult, if not impossible, for investors or creditors to determine. Again, we believe that the public has a right to know.
An editorial in Pensions & Investments that I mentioned earlier put it this way: ''Derivatives indeed are complicated instruments. They are difficult to understand. Even some big users fail to understand them, with spectacular consequences. But better understanding of these complex tools will be less likely if they are shoved to the back of financial reports.''
As for reporting gains and losses on derivatives in the balance sheet, losses on derivatives do not provide benefits to an entity, either now or in the future. Assets are supposed to be things that are of benefit to an entity. A loss just does not fit that description. Liabilities are supposed to be obligations, and gains are not obligations. Reporting losses as assets and gains as liabilities misleads investors and creditors and is wrong.
However, we have provided for hedge accounting for many derivatives. Gains or losses on derivatives that qualify for hedge accounting should have little or no effect on a company's earnings, because they will be offset by comparable losses or gains on the thing that is being hedged. The result is little or no volatility in earnings.
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Mr. Chairman, let me quickly summarize. This project is all about the public's right to know. The FASB is not opposed to derivatives as an investment instrument. It is not our place to regulate or in any way influence the use of derivatives. Our goal is to protect the public interest by making sure that investors and creditors have the information they need to understand companies that they might want to invest in.
The information about derivatives and hedging reported in financial statements today is incomplete, inconsistent, and just plain wrong. Better information is badly needed by all consumers.
Our due process has ensured that all interested parties, including financial institutions, have been heard from and listened to.
Our revised proposal is responsive to most of the concerns raised by financial institutions and others.
We have worked long and hard to find an appropriate solution. We understand that not everyone is pleased with the results, but no solution will please everyone. However, we have found a workable solution, and the time for action is now.
Thank you, Mr. Chairman. I very much appreciate this opportunity, and I now would be pleased to respond to questions.
Chairman BAKER. Thank you, Mr. Jenkins.
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Governor Phillips will testify later. I have also read comments of Chairman Greenspan with regard to the proposal. It appears that there may have been offered an alternate route for your consideration, which, interestingly enough, seems to be supported by the Basle Committee on Banking Supervision and others.
Under the approach, it would enhance the current historical cost-based financial frame; one, by issuing a derivative accounting standard based on best current accounting practices for derivatives, and, second, would supplement the historical cost-based statements with expanded disclosures based on fair values, including the fair value of derivatives and other financial instruments.
Without going on into detail, I am sure you are familiar with the recommendation, what defects or reasons would you see the profit-loss approach superior to that suggested by the Fed?
Mr. JENKINS. As you know, Mr. Chairman, I did respond to Chairman Greenspan's letter. His letter indicated that the FASB and the Federal Reserve really agree on the fundamentals that surround derivatives. We both agree that improved information on derivatives is needed by consumers, investors, and creditors; we both agree that credible, clear, understandable, and complete financial reports are extremely important in the market economy; we further agree that fair value reporting of financial instruments is the best conceptual answer; and, finally, we agree that greater transparency is needed in financial reports of enterprises using derivatives.
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The difference between the FASB's position and that of the Federal Reserve seems to be more one of timing. That is, when should we put these above fundamentals in place? We believe the time is now. In fact, with the change that the FASB has made from its exposure draft to today, with our revised proposal, we believe that our proposal today is much closer to what the Federal Reserve Board has in mind with respect to its simple approach, the changes that it suggests need to be made to the basic financial statements.
As a result, although I am sure there are some differences, we believe we are much closer today than we were at the exposure draft. It seems that the biggest remaining difference between the Federal Reserve and ourselves is the suggestion that in addition to those changes to deal with so-called abusive situations, that additional information, as you pointed out, Mr. Chairman, to provide full supplemental fair value statements for certain financial institutions, would be over and above what the Board has in mind and which we believe would cause some difficulties for both our constituencies, both the FASB and the Federal Reserve's.
Chairman BAKER. I share your concern about accurate and appropriate disclosure of financial conditions. I have read with interest the view that with regard to one market participant, Fannie Mae, if in fact the FASB rules had been in effect for fiscal 1996, shareholders' equity would have been increased, due to the reporting change, by $2.2 billion in that one year. This result, according to individuals who were analyzing it, would be directly attributable to the comprehensive income approach.
At the least it appears to me misleading, because that is not really what happened to the value of the Fannie Mae portfolio over that time period. How do we explain to people that reporting a $2 billion increase due to the change in reporting standards is a fair representation of true financial condition?
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Mr. JENKINS. Well, I am not specifically familiar with the Fannie Mae situation. However, I think the $2 billion number does reflect the magnitude of activity that is going on today in both the United States and around the world with respect to derivatives. Some estimates place it well above $60 trillion in terms of the notional amount.
What causes the transactions that Fannie Mae has suggested, I am not exactly sure of, but in a rising market, it may very well be that undisclosed transactions are being held off the balance sheet and off the income statement and out of equity in the interim because our accounting is not followed.
Now, it may be one thing if it is a $2 billion increase, maybe no one worries too much about that, although I certainly would from a fair presentation point of view. But what if it were a $2 billion loss that wasn't reported?
Chairman BAKER. Further, I am trying to understand the significance of the problem. We talk about the tremendous notional amount of derivatives being traded. There are about eight major financial institutions that account for about 90 percent or more of the derivatives transactions. Have any of the major accounting firms reported difficulty in providing appropriate information through the current system? Have there been actions taken leading to loss because of lack of appropriate disclosure in the last year?
Mr. JENKINS. I am not aware of any situations such as we experienced in 1994, for example, that have occurred recently. However, I think we need to understand the environment in which we have been operating, fortunately, over the last few years, since 1994, of robust and rising markets, of situations where these transactions have had a positive rather than a negative effect generally speaking, albeit still not disclosed.
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Chairman BAKER. I will make this my last question, because I am well over time, but the 1994 events, and particularly the Orange County activity to which I think you are making reference, even if the FASB rules had been in effect, there is not a representation being made that this would have changed those circumstances, because the judgments made in Orange County were not made based on lack of information. There was, in my view, more than adequate information that more than often wasn't read. Is that correct?
Mr. JENKINS. Again, as I said in my testimony, Mr. Chairman, our purpose is not to influence whether transactions in fact take place. However, once accounting standards are in place, the implementation of those internally within a company becomes necessarily a part of their internal control system.
Chairman BAKER. I appreciate the concern that it is not the intent to change decisionmaking. Unfortunately, I think the rule in its current form may do exactly that, where a derivative is used for the purposes of hedging a risk, given the new accounting standard that is proposed, one may well not even gauge in that activity for fear of the impact on the financial statement, that risk being greater in the mind of the manager than the risk of offsetting with a hedge.
Mr. Kanjorski.
Mr. KANJORSKI. Thank you very much, Mr. Chairman. Mr. Chairman, I arrived late, and I ask unanimous consent to revise and extend my remarks.
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Chairman BAKER. We have included it in the record already, Mr. Kanjorski.
Mr. KANJORSKI. Mr. Jenkins, it is interesting, you make the point that the reason the rule is being promulgated at this time is for consumer fairness, for the exposure of the information that an investor would need to know about a corporation to make an informed investment. Well, what about competitive fairness? We have a standard here that will disclose certain information that is proprietary in nature. An example, in Pennsylvania, the Hershey's Food Company. There is a point in why the Hershey's Kisses are on everybody's desk.
Mr. JENKINS. I seem to have missed getting mine.
Mr. KANJORSKI. You haven't responded properly yet to Hershey's and others' concerns on this issue. There is a situation where Hershey's alone constitutes perhaps 30 percent of the cocoa market, and cocoa is a necessary ingredient in their products. Protected more than their recipies themselves, is the way they hedge against the international cocoa market. As a result of your new rule, their competitors could easily know the future expectations of the company and its plans for the future and could interfere with the successful financial operation of the company if they knew just how they were hedging the market.
Now, we can all say, ''Well, once installed, this rule will be competitive for everyone.'' Oh, no, there are two major competitors, one is privately owned in the United States, and under SEC regulations does not have to revest that type of information in a financial disclosure statement. Their other competitor is an international company that is not under SEC regulation. So by the implementation of fairness, a consumer fairness rule, we are offering a tremendous burden of competitive unfairness to an American corporation.
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I think that kind of example applies to an awful lot of banks as well. If we are going to make sure we have a disclosure of our banks on hedging, and I think there are some bad operators who could get us into trouble in a bad market situation, obviously this rule is not essential in this great market we currently have, where we indefinitely will have success and it will go higher and higher and the world will always be profitable. We know these rules are made to protect us against the bad times, that is what the rules are for.
But isn't it grossly unfair for us to implement a rule of this nature that will work to the competitive disadvantage of our institutions, our companies, such as Hershey's, or our American banks in relation to the international banks that will not have to live under this rule in the same way?
Mr. JENKINS. We, the FASB, met several times with people from Hershey's, including the chairman of their board. I met with him personally to discuss this situation, and we have spent a considerable amount of time with them on the specific situation you describe.
We also considered several alternative approaches that the Hershey's people suggested to us.
We concluded that none of the alternatives would accomplish the required transparency of information that was important on an overall basis. But, more importantly than that even, we concluded and discussed extensively with them the fact that the information that would be provided, both in the financial statements directly and in the footnotes, would not, in fact, permit competitors to determine their hedging strategies.
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Because of the infrequency of reporting quarterly, as Hershey's does and most companies and banks do, while at the same time they are entering into these transactions daily, some of them are not opened and closed within the quarterly period, some of them go beyond one quarter, some for over a year end. And because timing and the timing you enter into these transactions and the time you close these transactions is so important in determining the impact, we were able to conclude and explain to them that we certainly did not believe in any way that these disclosures would reduce their competitiveness.
Mr. KANJORSKI. I suspect you and I are getting a different reading on that.
Mr. JENKINS. I am sure that is true.
Mr. KANJORSKI. Unless there could be a big business down here to keep people busy, but I suspect the information they are giving me, they believe they will be disadvantaged.
Mr. JENKINS. They are very concerned.
Mr. KANJORSKI. We have other alternatives. We could require private and foreign companies to follow the same accounting disclosure requirements, so we could equalize the field. In that instance, Mars and perhaps Nestle could be brought into public disclosure, Nestle because they are doing business in the American market, and Mars, amid some requirement that they must get an advantage from the Government that could require that.
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Mr. JENKINS. Could I respond to that?
Mr. KANJORSKI. Yes.
Mr. JENKINS. First of all, in the United States, if it is a U.S. company and it is a private company, even though they are not subject to SEC regulation, if they are to have audited financial statements, which they may very well, for use with bank loans and so on, private financing, it would be important that their auditor be in a position to give an unqualified auditor's report. That would only be possible if they followed the same rules that Hershey's would be required to follow.
With respect to the International Accounting Standards Committee has, within the last month, announced that it is the intent of the staff of the IASC to propose to their members yet this month that they adopt all of our financial instrument standards, all of the FASB, the U.S.'s literature, including the derivatives project, as their own standard.
Then, if Nestle follows IASC standards they also would be following the same standards as Hershey's.
Mr. KANJORSKI. Wouldn't it be good for all of us to go in this at the same time, as opposed to putting our corporations and our banks at a disadvantage? If there is any disadvantage?
Mr. JENKINS. If things were ideal, I would not disagree with you, sir. However, we were urged by this Congress to move rapidly, beginning in 1994. We started out with an expected effective date that already has been moved once, one full year, and now we are proposing it be moved another full year.
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It seems to me at the same time when this derivatives market is expanding so rapidly, now up above $60 trillion—and who really knows what it is today—and we have these situations as I described in my testimony, that we have waited long enough.
Mr. KANJORSKI. I am sympathetic to that answer, because I recall our wailing here and thrashing around in 1994 on how could this happen? Where were the accountants? Suddenly you have given us an answer. It sort of strikes me we were shoeless and we cried for shoes, and now we don't like the fit.
I would just urge that because this is a particularly devastating, or could be potentially devastating to some companies, and could put some American banks at a disadvantage. Although I am not at all certain if the economy stays healthy, isn't there some time frame here to allow us either to go into this standard worldwide, or to implement it at some later point to give us time to study what the impact would be, and give clever accountants time to think how they could increase the transparency of the financial statements?
Thank you very much, Mr. Chairman.
Chairman BAKER. Mr. Lucas.
Mr. LUCAS. No questions.
Chairman BAKER. Mr. Vento.
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Mr. VENTO. Thank you, Mr. Chairman. I guess we discovered the source of our ''chocolate kisses'' here. You know, the European Nestle has come out with a new chocolate square, and the problem is, they are introducing it into this country, and there are some allegations that three children have choked on the small ingredient, a figurine they place in the chocolate square.
I guess the concern here is everyone wants the accountability. We have asked for the accountants to do their job, but the question is, in the process of doing it, we don't want to end up with the banks being choked in terms of the role they play.
About two-thirds of derivatives are funded by the banks. It is becoming a principal instrument of liquidity and use within the financial marketplace. That is principally the concern. We want it, but the question is, does it change the regulatory regime? Your first statement is that you are suggesting that you do not want to have any impact, you just want to report. But the effect of this could be that it could, in fact, redefine or shape and have an impact on the market.
Mr. JENKINS. Well, you are correct that we do not intend to change the use or the desirability of derivatives.
I firmly believe, and I know my board does as well, that the decision that this Congress made in 1994 to move in the direction of better accounting, rather than banning certain types of derivative transactions, was the right one, because derivatives can play a very useful role in controlling risk, not only for banks but for other companies.
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But the issue is disclosure of what is being done. It is not a sure thing when you use a derivative that it is going to be effective in what you started out to do in the way of mitigating risk. So what we are after is better information about that so that there is full disclosure of that little figurine inside that chocolate, the derivative transaction.
I believe that for many companies, and perhaps even for banks, that derivative transactions in some cases are not entered into today because we do not have good accounting and because these transactions are not reflected periodically as they go. There is that risk of a buildup of surprise.
Also the uncertainty over the accounting and the lack of comparability from one company to another leads some companies to decide not to use derivatives as hedging and risk-controlling activities at all. I believe having the better certainty of a fair accounting standard that would apply to all and that would provide consumers with needed information on which to measure their risk will be beneficial overall to our economy and to individual companies.
Without knowing the risks and the extent of the impact of the use of derivative transactions, investors don't know how to measure the risk that is associated with making a capital investment.
Mr. VENTO. But the periodic measurement of that, for one thing, of course, some of the derivatives are actually traded more or less as securities, the Futures Trading Commission or the SEC regulation, but that is only a small portion of this, it is my understanding. Most of these are custom-designed types of derivatives, which would mean that almost on a daily basis you could have a different reading on what the mark-to-market value would be.
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Therefore, if you are looking at that, you are trying to standardize something that is a customized type of derivative, whether it is based on currency, whether it is based on mortgages. It seems to me to be very elusive.
Furthermore, of course, we are getting this information to the general public. It is open. As Hershey's said, it is open to their competitors, so this little figurine may be a poison pill sort of effort in terms of their raising costs that they have, and they lose, in essence, their proprietary information.
The issue that we would do this and the Europeans—in fact a lot of these derivatives do have, of course, an involvement that goes beyond the shores of this country and beyond the reach of our regulators with regard to the global marketplace.
Mr. JENKINS. That is true. We are a global economy and we are moving toward global financial standards as well.
Mr. VENTO. I understand the need for regulators to have information to do this, but whether or not this has to be as transparent in terms to the regulators, I understand it. And we have had an open transparency that has been very helpful, but the question is whether or not in the process of regulating, the process of providing the safety and soundness, that we go on in to shape the market or defeat it so it actually causes an atrophy with regard to banks and takes us out of playing this role.
If this goes offshore or somewhere else, you are suggesting the market is $60 trillion in notional value, so the banks are playing a big role here and we need to answer some of these questions. So I hope we can look at whether the two-tiered type of approach might be in the best interests until we, in fact, set in place and have acceptance of some of this, so it does not cause the type of instability I think that we do not need.
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We need predictability and certainty in terms of the marketplace.
Thank you, Mr. Chairman.
Chairman BAKER. Mr. Snowbarger.
Mr. SNOWBARGER. Thank you, Mr. Chairman. Thank you, Mr. Jenkins, for appearing before us today. I am going to have to apologize to you, because if you answer my questions in the way you want to answer them, it is going to fly right over my head. So please take that into account here.
There is not a lot that I understand about all of this, but it is my understanding that you are looking for the information that users of financial information can understand, and ''transparent'' is the word I think we have been using. I guess my question goes to the treatment of different kinds of assets.
Apparently, we think it is more transparent to look at derivatives in terms of their fair value, but it is my understanding there are other assets that would be included on a financial statement that would be shown at cost, or things of that nature.
Why are we saying that it is better information to have fair value for derivatives, but better information for other instruments to have it at cost?
Mr. JENKINS. We today, and for a long time, have had a model of financial statements that sometimes is called a ''historical cost model,'' but in fact it is not and has not been; it is more of a mixture. Some assets are on a historical cost, like a factory building, for example, or a retail store. But other assets are on at fair or market value. That includes today a large number of financial instruments, but not all.
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For example, investments that are held for trading purposes by banks today are held at fair value and are adjusted as they report. Many investment banking institutions and the like, brokerage, carry all of their assets at fair value and adjust them and actually do this daily, and that includes their derivative transactions that they adjust to value daily.
Mr. SNOWBARGER. But that is not required by FASB standards?
Mr. JENKINS. Yes, it is required. So derivatives are kind of a next step, if you will, in a fair value approach for financial instruments, including trading investments, equity investments, stocks and bonds and so on, and we do have a project to move forward.
Derivatives today, the problem is that, generally speaking, there is no accounting. They are recorded at cost only, because there is very nominal, if any, cost to enter into these transactions in the first place. Yet, as I explained in my testimony, they can be closed out like that, and they are always settled at the fair value at that point in time. So we think and believe strongly that fair value is the best measure.
What happened in the situations in 1994 that have been referred to is that there was no accounting, but they bet wrong, the hedge didn't work, it did not offset. One didn't go up and the other one didn't go down; they both went in the same direction, and there was a big loss, but it was a cumulative loss that occured over the entire period this transaction was in place.
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We believe investors need better information as they go along.
Mr. SNOWBARGER. I caught a phrase in what you were saying, you said you have ''a project to move forward.'' Was that in reference to bringing other assets, or maybe all assets, to fair value?
Mr. JENKINS. We have a project that will address the accounting for all financial instruments, both those that are on the asset side of the balance sheet and those on the liability side of the balance sheet. We are approaching it with an open mind, but with a presumption that moving toward fair value is the right answer.
There are many financial institutions and many banks that manage their business today on a daily fair value basis.
Mr. SNOWBARGER. I understand that. Is there a particular reason why we shouldn't be treating all financial instruments on the same time line? In other words, why are we doing derivatives now and then perhaps doing the others later?
Mr. JENKINS. That is the approach that we have taken for many years. It is a big change to move all at once. It is complex. These instruments are—the portion we mark to fair value on these instruments—is generally pretty easily measurable.
In addition, we also have today existing accounting for other things. We know how to account; if you have a mortgage on your home and you were to prepare a financial statement, you would know how to account for it. We don't know how to account today for derivative transactions, so we have to develop some accounting, and it seemed not only the best answer, but the right way to move, to move toward fair value for these derivative types of transactions.
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Mr. SNOWBARGER. Thank you, Mr. Chairman.
Chairman BAKER. Mr. LaFalce.
Mr. LAFALCE. Mr. Chairman, thank you very much for having this hearing. It is extremely important to Mr. Kanjorski.
Thank you very much for your excellent opening statements, and your Hershey's Kisses.
Mr. Jenkins, thank you for taking on a thankless task.
Mr. JENKINS. Thank you for thanking me.
Mr. LAFALCE. It is amazing how well-known you have become in such a relatively short period of time.
Mr. JENKINS. Yes.
Mr. LAFALCE. Mr. Jenkins, everybody should be for transparency and disclosure. I certainly am. It seems there have been and remain considerable difficulties with it. I have a few questions.
First of all, in yesterday's Wall Street Journal there was an article which indicated that a number of institutions that previously had been opposed have now come on board, in part because of changes that you have made to accommodate their concerns.
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Give me a political lay-of-the-land with respect to corporate America, their position on your present proposal, without considering financial institutions. Then, second, give me a political lay-of-the-land with respect to financial institutions that we are especially responsible for. Third, please compare and contrast for me, if you would, what you would do now and what the Federal Reserve Board proposes as an alternative, which alternative they allege would achieve greater transparency, greater disclosure, and greater probability of international harmonization.
Fair enough?
Mr. JENKINS. Fair enough. Thank you.
As to the first question, the political lay-of-the-land with respect to nonfinancial institutions. In the comments we received on our exposure draft which was issued in 1996, both financial institutions and nonfinancial institutions raised significant questions about our proposal and concerns.
What we have been up to in the 23 public meetings we have had since then is to try to deal with those concerns, and as a result, particularly for nonfinancial institutions, apparently we have largely resolved their concerns. Therefore, those that have commented to us are generally ready to move forward with our revised proposal and with the existing timing.
With respect to the banks, we received concerns on our exposure draft as well, and as one of the attachments to my testimony is a schedule where we looked at the major concerns of the larger banks and scheduled those down, scheduled how we responded to them, and just in terms of the eight or ten major concerns that they had, I think we met 70 or 80 percent of those concerns in our revised proposal.
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We were unable to accommodate the financial institutions with respect to all of their major concerns, but we did, in addition, move forward one year the effective date from 1998 to 1999 in response to their concern.
It is obvious, because of these hearings we are in today, that the banks have not embraced our revised proposal. However, we believe that we have accomplished a great deal in recognizing their concerns.
Hedge accounting is much more available today than it was in the exposure draft. Volatility is not eliminated, but it is significantly down. We have provided one full year from the proposed date of issuance for implementation to take place, which is a longer period of time than normal. We have given a longer period for comment on our revised proposal than we normally do. We have made our revised proposal available for comment to many more individuals and companies than we have in the past.
So we believe that while we, of course, have been unable to accommodate all of the banks' concerns, which I presume would be accommodated primarily by just going away, that we, nevertheless, have been very responsive to their concerns.
Now, your third question was with respect to, compare and contrast the FASB proposal today with the Federal Reserve's proposal. I think before you came in, I did respond to that question, but let me do so briefly again.
First of all, based on Chairman Greenspan's letter, I believe that we have a lot of agreement with respect to fundamental beliefs about derivative transactions and financial statements. First of all, we both agree that improved information on derivatives is needed by consumers, investors and creditors. We believe that fair value reporting of financial instruments is the best conceptual answer, and we believe that complete financial reports, the transparency that you mentioned, is extremely important in a market economy. All of those are points that Chairman Greenspan makes in his letter and which he, I and the board fully endorse.
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Our revised proposal, we believe, comes much closer to the first step in the Federal Reserve's idea, which was to adjust existing financial statements in a simple way for perceived abuses. By increasing the extent of hedging——
Mr. LAFALCE. Mr. Jenkins, we are not getting descriptive enough. If you could, tell me what you still propose to do that they do not like, and what they propose to do as an alternative and why you think that is inadequate.
Mr. JENKINS. OK. Well, first of all, with respect to their so-called ''simple approach,'' we don't know exactly what that is. It hasn't been fleshed out by them. We have had several meetings with the Federal Reserve staff and it is designed to make changes that are necessary to make sure that proposed potential abusive situations might be properly reflected. We think that is basically what we have done in our revised proposal.
The second part of their proposal is to add to the disclosures supplementarily a fair value set of financial statements, including a balance sheet and income statement for larger financial institutions. We don't require that at all. It is not our intent to require it, and we think that, consistent with the discussion with Mr. Snowbarger that I had, that we would find our constituencies not ready to move that far at this point in time.
So, that is the sum of the two differences. We think that we have moved much closer to their position with respect to abusive situations. It is only the speculative portion of attempted hedges, or the nonhedging, that will actually create volatility today in earnings. Then the supplemental fair value information in the form of full financial statements that we are not asking for.
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Chairman BAKER. Thank you, Mr. LaFalce.
Mr. Bachus.
Mr. BACHUS. Thank you, Mr. Chairman.
Mr. Jenkins, you heard what was said about Hershey's, that they are concerned this will affect their competitive advantage and that it will affect their operations. Are you comfortable in sort of trumping their opinion on the effect these rules will have on their own business?
Mr. JENKINS. I am not sure what you mean by ''trumping.''
Mr. BACHUS. You are actually overruling their objections by putting these rules into effect. You are basically saying it will not affect their business as they think it will.
Similarly, the banks are saying this is going to have an effect on how they manage risk. Are you comfortable with basically saying, ''No, it will not affect your business as you say it will''?
Mr. JENKINS. We have spent a lot of time, as I mentioned.
Mr. BACHUS. I understand all that. But do you have a comfort level with basically overruling——
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Mr. JENKINS. We believe we have listened carefully to the concerns of banks and companies like Hershey's and other commodity users.
Mr. BACHUS. You are going to basically overrule their objections?
Mr. JENKINS. We believe that our proposal will not be significantly competitively harmful.
Mr. BACHUS. All right. Don't you see their objections as a red flag? Does that cause you some concern?
Mr. JENKINS. No, I don't see it as a red flag.
Mr. BACHUS. What about 96 percent of the banks, I understand, have expressed opposition; is that a red flag?
Mr. JENKINS. Of course it is a concern. We would like our constituency, including preparers, to embrace our standards more wholeheartedly.
Mr. BACHUS. What about the fact that the FDIC, the OCC and the Federal Reserve have expressed strong reservations; is that a red flag?
Mr. JENKINS. It is not a red flag, sir, but it is a point where we have, again, explored carefully what is behind their concerns and believe that, on an overall basis, that our proposed standard is appropriate.
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Mr. BACHUS. So you are actually going with your opinion over theirs?
Mr. JENKINS. Ultimately, I guess you can say that. However, we have adjusted our standard to be responsive.
Mr. BACHUS. Who is Deb Harrington?
Mr. JENKINS. She an employee of the Financial Accounting Foundation, which is the organization that sponsors the Financial Accounting Standards Board.
Mr. BACHUS. Is she associated with FASB?
Mr. JENKINS. Yes, through that association she is.
Mr. BACHUS. How about with SEC?
Mr. JENKINS. To the best of my knowledge, she has no association with the SEC.
Mr. BACHUS. I am holding a memo from her dated September 17. I would like you to look at a copy of that. It brings to mind questions to me about FASB's independence from the SEC. Let me read the memo to you.
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From Deb Harrington, ''As you may already know, Business Week is working on two stories that will discuss FASB. One is the board's derivative project; the other is a portrait of Arthur Levitt.
''The derivative story is seemingly straightforward reporting of all the current events. The Levitt story, from what I have gleaned from the reporter, is a rather harsh treatment of Mr. Levitt and his bullying approach to several of his pet projects, including municipal securities, the FAF, and FASB (on derivatives, and so forth).
''Ed Jenkins has spoken with both reporters. We also have provided extensive factual information to them. Additionally, I have consulted with the Ketchum folks on the derivatives issue and have been in constant contact with Chris Ullman of the Public Affairs Department at the SEC.
''The articles are expected to be in Friday's issue of Business Week.''
Does this sound like an appropriate degree of independence from the SEC?
Mr. JENKINS. I personally don't see a problem with this. There were two articles, one was focusing on the SEC and one was focusing on the project. I was asked to comment on both articles. It seems a matter of common courtesy to inform the SEC staff when we receive comments about, in this case, Chairman Levitt.
Mr. BACHUS. It appears to me there was constant contact with the Public Affairs Department of the SEC, that you all are married in a public relations effort to push these rules forward.
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Mr. JENKINS. This has to do with two articles in a public magazine.
Mr. BACHUS. Concerning this issue.
Mr. JENKINS. One of them.
Mr. BACHUS. Should you be working in concert with the SEC, or should you be maintaining your independence?
Mr. JENKINS. The SEC does have oversight and responsibility.
Mr. BACHUS. So does the FDIC over the banks.
Mr. JENKINS. Yes.
Mr. BACHUS. This affects the banks?
Mr. JENKINS. I suspect that the banks——
Mr. BACHUS. And the Federal Reserve?
Mr. JENKINS. Yes.
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Mr. BACHUS. Some of your staff are shaking their heads, that the FDIC and the Federal Reserve Board and the OCC might not have any responsibility or role in this, but I would think it would be coordinated with them, too.
Mr. JENKINS. We have been in coordination, not on this article, but we have been in coordination.
Mr. BACHUS. Don't you think it would be appropriate to be in contact with the regulators?
Mr. JENKINS. Sir, we have been in contact with all of the regulators throughout this project. We have held meetings with the Federal Reserve Board, many meetings with the Federal Reserve Board before Chairman Greenspan's letter and after, and the Comptroller of the Currency and others on a regular basis.
Mr. BACHUS. I am going to submit that. One more question.
I think we all share concerns about adequate disclosure. But for one thing, the present risk management by the banks, in fact I think has led to quite a bit of stability and has been a plus, the use of derivatives. So that system is not broken. You hear the old adage, ''If it's not broke, don't fix it.'' If we need to fix it, we need to fix it, because we need to adequately disclose to investors what they are getting. But I think you are sort of using a bulldozer when a shovel might be sufficient.
I say that in that, wouldn't rigorous off-balance-sheet requirements take care of this problem, without interfering with the bank's ability to manage their risk?
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Mr. JENKINS. I think the banks can manage their risks any way they wish internally. We are not trying to drive that change. We are dealing here with a market of derivatives.
Mr. BACHUS. You would agree that they have to be concerned about their financial statements, and if they want to manage their risks, but it results in what appears to be great volatility, they are probably going to forsake that? You do agree with that, don't you, that this is going to have some effect on how they manage their risk?
Mr. JENKINS. I don't believe it will have a significant effect on how they actually manage their risk, no.
Chairman BAKER. Mr. Bachus, if I can, I have been generous with the time.
Mr. BACHUS. Thank you.
Chairman BAKER. Mr. Bentsen.
Mr. BENTSEN. Thank you, Mr. Chairman.
Mr. Jenkins, this is a complicated issue, and I am certainly no expert on derivatives. In fact, I think this may be more complicated, looking at your testimony and the backup, than President Clinton's health care plan was. But I do have a few questions.
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Let me start out. In your testimony, I want to take issue with a couple of things in your testimony. I think Orange County—and this subcommittee held hearings on Orange County—I think the problem in Orange County, there were really two things. One was what would appear to be malfeasance on the part of one of the officials, as well as his supervisor not doing their job, in overseeing it.
The second was in disclosure. The documents we looked at, the disclosure was horrendous in the offering documents.
The third, quite frankly, were the rating agencies, who gave a qualified opinion, but were giving really the wrong rating to what was a structured finance deal. So I think those were the main problems.
I agree that disclosure—in fact, I think disclosure is probably paramount to trying to retrofit financial accounting standards. Again, I am no expert in that, so you may know better; but the problems that I am seeing are that in trying to adjust the financial accounting standards, I am not certain that you have got everything in place, so you are trying to get started and say, ''We will start to have some form of a mark-to-market or fair value on one side of the balance sheet, but not on the other side of the balance sheet that will affect the income statement.''
At least that gives us partial transparency, but the end result may be more volatility. I am not sure if that is a positive tradeoff or not and whether or not greater disclosure might not be better. I mean, let me ask you a couple of questions about this.
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Some derivative transactions, I believe, are structured where the notional amount may go from a positive to a negative, above par to below par, over the life of the instrument, but that there is an assumed final contract date when it is supposed to pay par. Now, there is always the chance within that period of time that you bet wrong, that the market changes.
But otherwise, where the instrument is structured, would the structuring aspect have to show up in the income statement of the holder of the instrument, where at one point it would be below par, another point it would be above par? Even though that is assumed in the contract, would that still be something that is assumed in the income statement, or is that something that is disclosed?
Mr. JENKINS. Well, in our revised proposal, the one that we intend to implement at the end of this year, there would be no net income effect to the extent that that instrument was effective, was used for hedging and was effective in accomplishing the hedge. Because we really don't just adjust one side of the balance sheet.
For the portion of the derivative instrument that is effective, using it as a hedge, we do adjust the other side of the balance sheet as well, so that the increase in the one side matches the decrease in the other and there is no impact on earnings. It is only where the derivative instrument is not used as a hedge, or where a portion of that instrument is ineffective in accomplishing its objective of being a hedge, that there would be resulting earnings volatility.
Mr. BENTSEN. But the Chairman——
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Mr. JENKINS. Excuse me. That is a change that we made with respect to many of the aspects of these derivatives from the exposure draft to the current one.
Mr. BENTSEN. If I might follow up, how would that affect nonhedge derivatives?
Second of all, what about situations that, in your testimony, you talk about it, as well as in some of the documents you put out, where you are hedging against an instrument that maybe fair value was hard to determine? You mentioned commercial loans in your testimony.
The third thing is, are you certain that you can determine fair market value? Yes, some instruments you can. You can unwind things like repos and Treasury-type instruments, but others, is there a way to really determine fair market value? Are you confident of that, I guess? I just think you are correct that loans, for example, are hard to value in total. But another change we made was to permit the helping of just certain attributes of a loan, like the interest rate change in a loan in the marketplace. That is fairly easy to measure, the impact of the interest rate. If you have a derivative that you are using to hedge the interest rate exposure in a loan, you can adjust both sides to market value, but for the loan, you only need to adjust the market value of the interest rate portion. You need not to adjust the value for, let's say, changes in the credit risk of that loan.
So again, there would be—if the hedging is perfectly matched with respect to just the interest rate portion of the loan, there would be no volatility.
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Chairman BAKER. Thank you, Mr. Bentsen.
Let me suggest, as the subcommittee proceeds to recognize Mr. Campbell for his series of questions, subsequent to his questions, we will stand in recess. We have a couple of votes on the floor. I don't perceive we would come back to you, Mr. Jenkins, for additional questions, although I don't suspect you would want to leave.
You would be free to go, if you choose, after Mr. Campbell disposes of his questions.
Mr. CAMPBELL. Thank you, Mr. Chairman. I will make my questions two. One is technical. Let me just see if I get it right.
I buy a bond and I intend to hold it to maturity, but I am worried that interest rates might go up, so I also buy something in the nature of a put instrument. Interest rates do go up. The value of that put instrument goes up, and I have to reflect that under your new rules; but because I am holding the bond to maturity, I don't reflect the fact that its value has dropped. If I am right, your rules result in making me look better than I am.
Mr. JENKINS. We have, in our document—with respect to bonds that are held to maturity, that is a designation that a financial institution makes at the inception of when they acquire the bonds. We have provided in there an opportunity for them to change that designation as a part of adopting this standard, so if they want to use derivatives to hedge interest rate changes on debt held to maturity, they can reclassify that debt to one of the other categories that is mark-to-market.
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Mr. CAMPBELL. If they don't, because they are unscrupulous and wish to appear better than they actually are, they do not have to avail themselves of that option, and the result of the change in your rules is they can get away with it?
Mr. JENKINS. Well, first of all, it would be quite a bet to make, because once they enter into the instrument, they would be stuck with it. But second, it would reflect reality to date.
Mr. CAMPBELL. I disagree. Pardon me, Mr. Jenkins.
Mr. JENKINS. One more point on it.
Mr. CAMPBELL. Sure.
Mr. JENKINS. Hedging, you do not have to do hedge accounting. No one requires you to do hedge accounting. You can can just mark this to market.
Mr. CAMPBELL. I am with you when you make the point, and I'm sure it is sincere, that you want to get full disclosure of value. And you talked about why you don't mark-to-market on a factory. But it seems to me you should do both the same way, either if the derivative is going to be mark-to-market, then the underlying security ought to be, or if the underlying security is historic cost, then you should not mark-to-market on the derivative.
Let me just ask, did I get it right? Maybe you don't like my characterization, but did I get my facts right? Is that example correct?
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Mr. JENKINS. In the second example, yes, that is right.
Mr. CAMPBELL. That troubles me greatly. I will allow you to respond all at the same time and then I will be done.
One other concern I have is, believe me, I want you to be independent and right on the merits. I don't want you to be influenced at all in the best exercise of your judgment by the Congress or the SEC.
Now, my colleagues' questions troubled me, so I am just going to ask, in terms of who thought this up and as the process went through when you got feedback, did you do something differently because of what the SEC suggested? Those two things are yours to respond, and I won't interrupt you anymore.
Mr. JENKINS. OK. Thank you. Let me respond to the last one first, because I know your time is precious. That is an important question.
I can say that during my time as Chairman of the FASB, which is short, 3 months, I have not received any calls from the SEC, from the Chairman, Arthur Levitt, on down, trying to influence our approach or our actions on derivatives, the timing of release of the proposed final standard, the effective date that we chose, or anything else.
My understanding prior to the time that I became Chairman is that, well, the SEC, coming from 1994 and before and as a result of all that has gone on in Congress and the GAO and elsewhere, has been a strong supporter of improving accounting for derivative transactions in the interests of investors, which is their mission, which they must do. They have chosen, as they have chosen for over 60 years, to have the FASB, in an objective and uninfluenced way, determine those accounting standards.
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My understanding, from the period of time that started until I became chairman, is that that has taken place.
Chairman BAKER. Mr. Chairman, if I may, Mr. Lucas had one further comment he wanted to make before we break.
Mr. LUCAS. Thank you, Mr. Chairman.
I would note that we had tentatively scheduled a witness from the National Grain Trade Council who apparently could not—our schedules did not work well at this hearing. But I would also observe that, based on their advance testimony, I think they raised some interesting points, and I would suggest if we have another hearing in the future, we consider potentially inviting such a witness.
I would observe that I may direct, by writing, some inquiries to Mr. Jenkins based on some of the things that I have noted.
Chairman BAKER. Thank you, Mr. Lucas. I am advised that other Members may have additional questions to submit.
Mr. BACHUS. Mr. Chairman, I don't have a question, but what I do have, I have an opening statement.
Mr. BACHUS. Also, Mr. Kanjorski on his opening statement, attached some questions which I think are very relevant. I would just ask you to maybe review these opening statements. I have only a few questions.
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Chairman BAKER. We will forward them on your behalf and Mr. Kanjorski's.
Mr. BACHUS. And answer his questions, if you wouldn't mind.
Chairman BAKER. We have another Member, Mr. Kanjorski, for the Record, who is to introduce another question.
Mr. KANJORSKI. Mr. Chairman, I have been designated a surrogate for Mr. Schumer. In absentia, he would like to ask a question in regard to this. I will get right to the question.
''What does FASB perceive are the costs and benefits of this rule, and have you attempted to quantify them?'' And you do not necessarily have to answer that, you can submit it to Mr. Schumer.
Assuming that they haven't been quantified, has FASB considered delaying the implementation of this rule until this analysis is done?
And a little follow-up by myself: Have you done the tax implications of this rule and what has that analysis shown for these various entities?
Mr. JENKINS. Did you want me to answer that last one now?
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Mr. KANJORSKI. It is up to the Chair.
Chairman BAKER. Let me add to the pile.
Mr. JENKINS. I hope the reporter is making a record of this, because I am not.
Chairman BAKER. Mine are very basic.
As of the moment, it is your intention to make no further modification to the proposal, and to promulgate, in effect, by October 14, or move forward to the SEC by October 14, the proposal as it currently stands, just to understand your perspective.
Mr. JENKINS. That is not our proposal.
Our document is out for comment. On October 14, when the comment period ends, we will consider, individually and as a board as a whole, in public meetings what we have learned from those comment letters. To the extent that there are changes that are important to be made as a result of those comment letters, we will modify our standard.
We still would intend to issue it before the end of December, 1997. We will listen to additional comments, as we always do, with respect to the effective date issue, but at this point, we certainly plan to make it effective in 1999.
But we will listen to all the comments we receive, carefully analyze them, discuss them in public meetings. It is usual at this stage of the game to make minor modifications in a standard as a result of what we hear from our constituents through their comments, and I expect that there will be some changes that we will make as a result of this.
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Chairman BAKER. I appreciate your courtesies.
That is, I think, the 5-minute notification. We will stand in recess.
For those who have yet to participate, I understand it is more than one vote, so we may be absent for a few minutes. We will return as soon as possible. Thank you.
[Recess.]
Chairman BAKER. I would like to reconvene this meeting of the Capital Markets Subcommittee, and we will come to our next witness to the subcommittee, the Chairman of the Securities and Exchange Commission, Mr. Arthur Levitt.
Mr. Levitt, I am told that Members are concluding business on the floor and should return momentarily, and I do expect to have most of our Members back in just a brief moment.
If you would choose to proceed, that would expedite our hearing. Thank you very much, sir.
STATEMENT OF HON. ARTHUR LEVITT, CHAIRMAN, U.S. SECURITIES AND EXCHANGE COMMISSION
Mr. LEVITT. Chairman Baker, I am pleased to testify today on behalf of the Securities and Exchange Commission regarding accounting for derivative financial instruments.
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A few moments ago we heard the distinguished Chairman of the FASB, Ed Jenkins, discuss the need for improved derivatives accounting. I commend him and his colleagues for their steadfast efforts.
I am not here today to persuade you of the technical merits of the FASB's proposed standard, although my lifetime of work in the securities industry tells me that they have gotten it about right. It is a thoughtful, measured proposal that meets the test of improving current practice by promoting comparability and providing badly needed transparency to financial statements.
My remarks today focus on this Nation's critical need to maintain the independent process by which we establish accounting standards and the enormous value that accrues to our economy by keeping this process out of the hands of the Government and in the private sector.
Much of the debate about accounting for derivatives has been healthy and, I think, necessary. Extensive public input and vigorous discussion are great American traditions and are critical for the development of sound policy in this area, as in so many others.
From my vantage point, however, there is now more at stake than even this important issue of whether derivatives have economic value that must be accounted for. Some are challenging not just the proposed rule, but the private standard-setting process. This is a significant threat to the vitality of our markets and their ability to retain their preeminent position as we enter the 21st century.
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For more than 60 years, the Commission has exercised its statutory responsibility to regulate financial reporting by looking to private sector organizations to set those standards under SEC oversight. The result has been accounting practices that are respected in every corner of the globe. Most of us are aware that people from around the world come to the United States to study in our universities, to work in our companies, even to obtain medical care in our hospitals. They do so because Americans in so many professions establish the state of the art, the very highest and best standards that frequently serve as a model for others.
Our financial accounting system is less visible than our educational or health care systems, but it plays a fundamental and crucial role in one of our most important national institutions, the capital markets that sustain our economy and our standard of living. We have the best capital markets in the world and the best accounting standards. I submit to you that this is no coincidence.
Reliable and credible accounting standards are the foundation of fair and accurate financial reporting, and fair and accurate financial reporting is the foundation of the process by which capital is raised and allocated. In an era of complex global markets, when silicon chips and fiber-optic cables allow capital to move across borders at lightning speed, it has never been more important for the United States to have an independent body standing guard over those standards.
The objectivity and fairness of standard-setting can only be guaranteed if the process is shielded from political pressure, special interests, and bureaucratic expediency. We should not succumb to the temptation to undermine a process that has resulted in careful and unbiased, though sometimes difficult, judgments. Let the experience of the National Base Closing Commission, on which I served two terms, stand as a warning. We tamper with independent processes at our peril.
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The FASB is not immune to criticism and change, but there is a world of difference between constructive advice and intimidation. Let me be clear. ''Independent'' is not and should never be a synonym for ''insulated'' or ''unresponsive.'' Comments and criticism that better inform the board about crucial issues are always welcome. Pressure to undermine its independence is not. It is ironic to me that some of those who would limit FASB's independence argue that the board is antibusiness. To me, that is like suggesting the College of Cardinals is anti-Catholic.
Ed Jenkins outlined why investors want and need this rule, and described the careful and painstaking deliberations that led the FASB to propose it: a decade of study, thousands of hours of staff time poring over comments and analyzing alternatives, field tests, and more than 100 open meetings and public hearings.
It is extremely significant that as a result of this process, the FASB modified its proposal. Those changes led companies such as General Motors, McDonald's and Berkshire Hathaway, and institutional investors such as T. Rowe Price, Vanguard, and the Nation's largest pension fund, TIAA/CREF, representing millions of teachers and educators around the country, to declare their support for this rule.
I think it is self-evident that due process has always been a touchstone at the FASB. Nevertheless, some are now arguing for a delay of a year or more in the effective date of the proposal. To put this suggestion into perspective, however, I ask you to think about the Congress' recent decision to commit the Nation to a balanced budget by the year 2002. There certainly were many special interests who pleaded for delay, who asked to extend the period for a few more years to avoid making difficult decisions.
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The Congress, mindful of the maxim that ''Justice delayed is justice denied,'' declined to do so. It determined that it was unconscionable to pile any more debt on the backs of future generations and that our Nation's interests could not be deferred another day. I believe similar considerations are present here.
Mr. Chairman, the backdrop for today's debate is a market that continues to surge at a time when tens of millions of investors pour their hard-earned dollars into stocks, bonds, and mutual funds. But the unprecedented duration of the current bull market can obscure many things, including the fact that what goes up can just as easily and just as quickly go down. That is what happened in parts of the derivatives market in 1994, when interest rates spiked upward, leading to extraordinary and, in some cases, devastating losses that took almost everyone by total surprise. Americans saw hundreds of millions of their investment dollars vanish as major derivatives positions went sour at well-known companies such as Eastman Kodak, Gibson Greetings, and Proctor & Gamble.
Indeed, this subcommittee thoughtfully examined a similar problem when you held a series of hearings about the derivatives calamity that occurred in Orange County, California. Each reported derivatives loss brought forth calls, some from Congress, some from editorial pages, for severe restrictions on their use. But the SEC and other regulators, including my colleagues at the Federal Reserve, resisted those calls. We chose instead to ensure that the impact of derivatives are better communicated to the marketplace and to America's investors.
Mr. Chairman, in protecting FASB's autonomy, the Congress and the SEC are stewards of a profound and a unique public trust. Our capital markets are among our Nation's most spectacular and enduring achievements, not only in their depth and liquidity, but also in their fairness, in their transparency. Those markets, and investors' confidence in them, are a rich legacy we have inherited but do not own. They are a national asset we hold in trust for our children and the generations to come. Our highest responsibility is to preserve that trust and, where possible, to build upon it.
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Thank you.
Chairman BAKER. Thank you, Mr. Chairman.
Are you familiar with—what is the acronym—the VAR model for financial risk analysis within national banks?
Mr. LEVITT. The which model?
Chairman BAKER. The ''value at risk.'' It is called the VAR model.
Mr. LEVITT. In general terms.
Chairman BAKER. In general terms, it is an acknowledgment by the Fed that due to the sophistication of financial products in today's market and the reporting technologies which exist in some selected financial institutions, their risk profiles are more sophisticated and responsive to day-to-day financial condition than the ability of the Federal Reserve's skilled, but overwhelmed, agency in keeping track of the true financial picture.
The reason why I bring that up is the observation about the VAR model, now having been in effect for some time, is that the risk-hedging activities and managerial skills utilized by individuals within those institutions in fact results in a healthier marketplace than in, all too often, the onerous encroachment by a financial regulator into the day-to-day business activities of that institution. It is pointing in the direction, which is my principal, underlying concern about this whole matter, that derivatives are just one small portion of a very complex financial marketplace. For us to accurately gauge a financial institution's true financial picture at any given moment is very difficult for a regulator to do on some prescribed plan which isolates one portion of the portfolio and gives it special treatment.
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There are a number of assets and liabilities of the bank which are carried at book value, which may not have an accurate day-to-day, mark-to-market representation. By taking this slice and moving it into these new accounting criteria, the point earlier made by Mr. Campbell was exactly the point I have been trying to make.
We are all, on this subcommittee, for transparency. We don't want anyone to make an investment decision in this country without having adequate tools and the best information available to make that judgment. Our fear is that by moving partially, rather than wholly to mark-to-market, we are going to get a skewed result in the marketplace.
I earlier got Mr. Jenkins' response, but I would like for you to have the opportunity. No need for me to recite the elements of the Federal Reserve's proposal that Governor Phillips will later speak to. Do you have specific concerns, or are there particular deficiencies that bother you with regard to the Federal Reserve's proposal in moving more toward your direction but not to the rule which FASB now has proposed?
Mr. LEVITT. I have obviously read and discussed with Chairman Greenspan his reservations about the proposal. I think we view this issue from different perspectives and from the standpoint of different constituencies. I believe that the VAR rules are very constructive ones. As a matter of fact, we are preparing a concept release now to make it possible for securities firms to treat capital in a different fashion.
I guess the principal reservation I have—the principal difference that separates Chairman Greenspan's view from mine—is that I view the process of standard-setting as an ongoing, continuous, evolutionary process. There is no absolutely correct, total, comprehensive standard because our business community is a constantly changing, evolving entity. Our markets constantly change and evolve.
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I think that the steps taken by the FASB to bring a measure of clarity to derivatives at this point are absolutely essential, because, in my judgment, investors are totally naked today in terms of understanding risk.
I have held 20 town meetings throughout America to hear thousands of investors come out and ask questions, and those questions invariably center on risk. ''How can we tell the difference,'' they ask me, ''between the risk of this fund or this investment and another?'' And ''how do we know whether they have derivatives in there?'' And I must say that the rules presently in force are confusing and obscure, and we are talking now about a time when we have seen the markets go up for almost 14 years. We haven't seen a major derivatives accident in nearly 2 1/2 years now; and I am worried about the fact that those investors do not know enough about what America's corporations are doing, and that is why I am supportive of the process and supportive of the rule.
Chairman BAKER. With all due respect, no matter what disclosure FASB's promulgated rules may require, that, in itself, is not going to lead to a consumer having a better insight into a futures or a swap.
Mr. LEVITT. I think it will. A FASB rule may be obscure to the typical investor, as it probably is to any nonprofessional. But, we have today the most sophisticated methods of analyzing information and increased press attention to these matters. Because of the sophistication of securities analysts around the country, nearly all of whom support greater clarity in terms of reporting on derivatives instruments, a change in this rule will very definitely result in enhanced information to be interpreted by those analysts and then reported on that media for the benefit of America's investors.
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Chairman BAKER. I think that is a hopeful outcome. Few people ever read their life insurance policy. I don't think it is a lack of information that causes——
Mr. LEVITT. We can't play to the lowest common denominator.
Chairman BAKER. I certainly agree, but I don't think we should confuse what is a troublesome landscape already.
Mr. LEVITT. I don't think it is confusing at all. I think that the proposal brings clarity where there has not been clarity before. It brings definition where there has not been definition before. The major analyst groups of America have all been very supportive of this proposal.
Chairman BAKER. Let me move to another point, which concerns not the elements of the proposal itself, but the process by which the proposal has come forward.
You mentioned in your written testimony General Electric and Berkshire Hathaway and others. Have you had reason to contact any of those firms, asking them to either oppose, support, or take any position with regard to this proposed rule?
Mr. LEVITT. I have not contacted any of the companies that you mentioned. I must say to you that I spent the better part of my life in the business community. I have known and know many of the leaders of the business community. Through the years I have discussed these issues, sometimes from different perspectives, with those leaders. I have sought their advice and sought their counsel and sought their judgment. But I think it is reasonable to say that I have had no contact with executives from any one of those three companies with respect to this issue for the past several years.
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Chairman BAKER. My point, rather than those specifically, although you mentioned those three in the written testimony, is that in the course of maintaining, and I quote, ''We tamper with independent processes at our own peril,'' I don't know that it was intended, but I took that to mean this congressional hearing was in some way attempting to tamper with what FASB might be doing.
That is clearly not our intent. We are only responding to what we perceive to be, and apparently not correctly from your view, the consequences of these new regulations.
Secondarily, my concern has been the process by which these recommendations have now been formulated, not with respect to the actions of Mr. Jenkins, particularly. He hasn't been around long enough to wade off into it significantly. But it is my opinion, based on press accounts, that you have spent considerable time and effort in contacting the regulated constituents of the prospective rule and either encouraging them to support or encouraging them not to publicly comment. I think if we are to remain independent in this process, that that requirement should fit for us all throughout the entirety of the comment period.
Mr. LEVITT. I agree with that, Mr. Chairman. I would say to you—I would like to explain the remark at greater length, that I made in my opening statement.
I served for two terms on the Base Closing Commission. Those were very tough decisions we had to come by.
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Chairman BAKER. I was one of the ones closed. I recall.
Mr. LEVITT. And we were subject to all kinds of pressures. I don't believe that there was a better process for arriving at those tough decisions, and I think most Members of Congress would agree that the people who served on the commission certainly didn't win any accolades for what they did; but it was probably the only way that process could have been accomplished, and our military posture was vastly improved as a result of some of the efficiencies that were brought into play.
Chairman BAKER. I agree.
Mr. LEVITT. I feel very much the same way about this process of independent standard-setting. I can think of no better way to arrive at the kind of standards that are the envy of the world, that make our markets the most transparent and with the lowest premium, or cost burdens, placed on investing than the process which exists today, and I greatly fear interference in that process.
What I mean by ''interference'' is, I studied the history of the FASB; I suffered from some of their rules and their regulations when I was in the business community, and I have argued against them through the years. But I can think of no better way to come up with the kinds of standards that make our country's standards the envy of the world. And I am going to jealously protect their independence as fiercely as I possibly can.
I understand that our appropriate role is an oversight role, and I understand that full well. But I feel that the role of the commission must be to defend, not to interfere with, but to defend the FASB. Only in those very rare instances, I believe only twice in history, where the commission feels that they have not taken into consideration certain factors, has the commission ever been less than supportive of the FASB.
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Chairman BAKER. I commend you for that perspective. My point was going more to the issue of letting FASB do their work and remaining out of the fray until the public comment period had concluded. It is my perception that there was active involvement in the marketplace among the regulated entities, suggesting to those individuals they not participate in critical comment as to FASB's proposal. That is what is troubling to me. If we as Members of Congress are to stay out of the considerations, so should all other parties, and let the independent professionals work. I don't perceive that that is what, in fact, has happened.
Second, with regard to base closure, a process I did support and voted for, my own best interests notwithstanding, there was a vote by the Congress as to the overall concept. We didn't amend it. We couldn't fiddle with it, but an up-or-down, yes-or-no vote on whether this was ''good public policy.'' I don't see that as being significantly different from the question at hand if we, in fact, come to a proper understanding of what the consequences of these rules are. I don't know that Members of this subcommittee, and I will certainly confess that I am not sure I will understand fully the implications of all derivatives and their impact on risk hedging, and I am not putting myself in any position to say that the professional members of FASB have come to some erroneous conclusion. What I am saying is that there are other professionals, in my judgment of equal standing in the financial marketplace, who are suggesting that this deserves a little longer look.
At the end of the day, I strongly support more transparency and, frankly, more accountability, which brings me to one last point. Let's assume for the moment the rules are promulgated, they go into effect, January of 1999, and a year later we find out they are wrong. To what cost has the market gone, and to what inconvenience have investors been put, and what accountability will FASB have, or the SEC for that matter, if that is the untoward outcome of this process?
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Mr. LEVITT. I think that in almost every decision that is made by any regulatory body, there are enormous consequences. Hardly a day goes by when I don't look into the mirror and say to myself, ''Am I absolutely certain that the many decisions I am obliged to make today that may affect millions of people and thousands of businesses, am I absolutely, totally certain that I am right?'' And I don't think once since I have been in this extraordinary job have I ever come to that response.
So I say to you that, in weighing all the pluses and the minuses, I believe that obtaining better accounting in this area at this point in time is absolutely essential. If we took ourselves back to two years ago, where we had all kinds of problems in the derivatives area, some might not be as sanguine as they are today about the possibility for delay. I believe we can't afford delay. I believe that we are playing Russian Roulette by delaying.
I can't say to you that this is the absolute answer. This is work in progress, just as every decision made in this arena, every decision made by the Congress, is work in process. But I think it is important work to be done and done now.
We have been at this now for over five years. The proposal won't be phased in for at least another year. The bulk of the business community is supportive of this. We have had hundreds and hundreds of hearings on it. I believe the process is adequate to have arrived at the point that we are now, to protect America's investors.
Chairman BAKER. So I take it, any further delay that the Congress might suggest would be viewed as highly inappropriate?
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Mr. LEVITT. I would feel it would be very inappropriate for the Congress to suggest additional delay. I think we would be playing Russian Roulette by taking that action, in my judgment, with our markets today. Derivatives are not new instruments.
I take myself back to 2 1/2 years ago where I attended hearings in a room not too far from here, where I was badgered and asked and pressed to ban the use of derivatives products.
I think that would have been a grave mistake. Derivatives can be a really wonderful and a very important product, and we couldn't ban them, even if we chose to. So I believe that a delay would be very ill-advised.
I believe that we should take all of these factors into consideration, as I am sure the FASB is in the process of doing, and make whatever amendments they believe are appropriate during this comment period; but I do believe, respectfully, Mr. Chairman, that we should proceed, that we should not delay this implementation.
Chairman BAKER. Thank you, sir.
Mr. Campbell.
Mr. CAMPBELL. Thank you, Mr. Chairman.
Mr. Levitt, you were here, I believe, when I had a short chance to talk to Mr. Jenkins. I put to him the suggestion that if you are going to mark-to-market on derivatives, you ought to mark-to-market on the underlying and that the historic cost for hold-to-maturity instruments is an inconsistency. Do you agree?
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Mr. LEVITT. I am not prepared to answer that question. I am not going to address the accounting consequences of that particular action today. I would prefer to reserve judgment on that and communicate with you after the hearing, if that is agreeable.
Mr. CAMPBELL. It sure is. I don't want to ever ask anyone to go beyond where they are comfortable in testifying. But I do wish you would be kind enough to remember to do so.
Mr. LEVITT. I will do so.
Mr. CAMPBELL. And to maybe consult the record.
My feeling is that there is no substantial background at all, but this one is a problem which shouldn't have been there. If mark-to-market is the right way to go, then go mark-to-market; if historic cost is the right way to go, then go with historic cost. But to mix the two appears to me so clearly inconsistent with the desire of understandability as to call into question the result. If you would like to speak further, tell me further on that by writing, I would be grateful.
My second and last line of inquiry is along the lines of the Chairman. I share your desire to keep FASB very independent, and you do get badgered a lot and FASB gets badgered a lot. I would rather that FASB's judgment be exercised and your judgment be exercised absolutely on the merits. Nor am I calling that into question with regard to you.
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I do want to ask, though, if you feel so strongly about this, why didn't you propose this as an SEC regulation: that if you are going to be traded on a major stock exchange, if you are going to be traded subject to the jurisdiction of the commission, then this is a rule that you must follow?
That, it seems to me, would keep it very, very clear; that you think it is important, your fellow commissioners think it is important, and if Congress disagrees, we have got lots of oversight opportunities for SEC.
The problem is when, instead—and I am saying this so that you can correct me if I am wrong—when instead you appear to be strongly suggesting that FASB take a particular position, that it isn't the same as you putting it forward, as you could, through a regulation. So I would like to know why you didn't consider going the regulatory route that you have the authority to do for the accounting practices of those firms that are listed on the exchanges that come within your jurisdiction?
Mr. LEVITT. Well, let me answer that simply by saying that I have seen all manner of divisive issues in this country almost cause paralysis in the decisionmaking process because of the tug and pull of different legitimate interests. I guess my experience on the Base Closing Commission, and I guess my observation of the Social Security Commission, and when I was in the private sector, my views of the FASB, tell me that this is probably one of the best processes in the world to handle divisive issues.
The FASB was established to handle accounting issues, and I think they have done a remarkable job. I view my responsibility as Chairman of the SEC to be an overseer of that process, to see to it that it represents the public interest, and to see to it that it doesn't create distortions which are so disruptive to the economy or to investor interests that they are counterproductive.
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I think that, if we were to undertake the process of setting standards—and I wouldn't distinguish this from many of the other very controversial standards that the FASB has dealt with in recent years—the process, in my judgment, would break down. The process may very well become politicized. The process would be—can you imagine if you had a congressional committee trying to decide which bases to close and which not to close? It is for that reason that I think the FASB was wisely established, and why I view my role as their overseer and as their protector.
Mr. CAMPBELL. My question, with the Chairman's indulgence, because I know the red light is on.
Chairman BAKER. I think the other Members will be patient.
Mr. CAMPBELL. I hope so. Now is the time to bring up that renaming of a Campbell Courthouse bill.
Mr. LEVITT. I am for that.
Mr. CAMPBELL. Then I have no further questions.
The danger is, if the SEC, for all of the good reasons that you suggest, nevertheless becomes more than just overseer, protector, and becomes participant—that is not a pejorative word—but participant maybe in what is going on.
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As I understand it, you have been strongly involved in initiating the FASB action and in keeping their feet to the fire and in seeing it through; and it was from that point of view that I said, if you have an absolute, legitimate role, do it through the regulatory process, and if you don't do it through the regulatory process, then I am troubled to the extent that my understanding is correct.
And that understanding is—so I am putting it out here and you can tell me it is wrong if you would like—is that this action by FASB has a strong element of SEC origination and maintenance of effort.
Mr. LEVITT. Let me address that question, because I have heard it before. Those people who knew me in the business community knew me as being kind of a restless personality who liked to see results. Projects which lasted years frustrated me.
When I came to this most extraordinary job that I have had the honor to hold, I was confronted with the fact that, for some three years before I got there, the FASB had been wrestling with this project. I am not an accountant. I couldn't begin to argue the fine points of accounting rules, but at an early meeting with the FASB—each year they come to us and tell us what is on their agenda—I urged them to move ahead with various projects that had lingered for too long.
One of those projects happened to be stock options, and together, we terminated that project in a certain way because we couldn't reach a resolution.
But, I also went through a period when I attended a congressional hearing in which I was urged, in no uncertain ways, to use the powers of the commission to ban the use of derivatives. I felt that would have been a national economic calamity. I didn't think, furthermore, that we could make that decision, so that I urged the FASB to move on with that project and bring it to resolution.
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I never suggested to them what that resolution should be or how it should be, and the notion that I am driving that project is a fiction. I am not driving that project, but I firmly believe it is in the national interest that we bring a measure of clarity for investors in the use of derivatives.
I view the role of the commission and the chairman of the commission as being the protector of investors; that is our first and foremost responsibility, and to nurture the process of capital formation. These, in my judgment, are complementary goals, and the resolution of this issue is an essential factor in providing for the flow of capital and also for protecting America's investors.
I certainly do not intend to promulgate accounting rules.
Mr. CAMPBELL. I heard you say, and I just want to be sure that I got it right, that at no point did you weigh in on the substance of the FASB rule. Is that correct?
Mr. LEVITT. Let me clarify that by saying that I have said on a number of occasions that it was a reasonable rule. I never got involved in terms either with FASB or on behalf of FASB or in terms of testimony before any public body. I never, ever, suggested that the rule go in this direction or that direction. I just wanted a rule, I wanted it clarified, and that was it.
Mr. CAMPBELL. Nor did you suggest it in private with FASB either?
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Mr. LEVITT. No, absolutely not. I did not get into the fine points of the rule. I did not get into a discussion of what the rule should be. I just wanted the issue resolved.
Mr. CAMPBELL. Thank you.
Thank you, Mr. Chairman.
Chairman BAKER. Thank you, Mr. Campbell.
Mr. Levitt, as a follow-up with regard to the advisability of a delay, I understand that AICPA, the organization with several hundred thousand accountants, has called for an implementation delay of at least a year, apparently out of concerns about complying with the rule requiring additional time to get corporate books in order.
Do you think their request is inappropriate at this time in light of their professional concerns?
Mr. LEVITT. I am told that the staff of the AICPA favors going ahead with the rule as it is with no delay. I have read about a committee of the AICPA that considered the issue of a delay and recommended it, but I believe—and I am going to now ask the chief accountant of the SEC to verify this—that the AICPA staff, the leading body, has recommended going ahead as it is.
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This is Mike Sutton, the Chief Accountant at the SEC. If I may ask him to come up?
Chairman BAKER. Certainly, please.
Mr. SUTTON. My understanding is that the committee you are referring to is the Accounting Standards Executive Committee, which is a senior technical body that is responsible for, among other things, commenting on FASB proposals. The point you referred to, I understand, was raised in the discussion of their planned comment letter that they were going to issue on the FASB proposal.
My understanding is that that letter is expected to be strongly supportive of the rule, strongly supportive of issuing it, and it does raise a question, as I understand it, about the timing, whether the implementation should be delayed a year or not.
I am also aware that the AICPA board of directors has issued a resolution, or statement of some sort, in support of the FASB proposal as well.
Chairman BAKER. Right. I think the issue I am going to is the Chairman's response to the earlier question, ''Is any delay advisable?'', and his response was ''No, it is not.'' I am basing mine on a Wall Street Journal article of September 16, but I always verify these things, saying that the ''Institute of Certified Public Accountants will ask that the effective date be changed to January 1, 2000, instead of its current target date of January 1, 1999.'' It goes on with reasons.
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My point being, Mr. Chairman, are there any conditions which would warrant a delay, in your mind?
For example, if the October 14 date is the closure of the FASB's public comment period, between then and the first of the year, I conclude they will then take all the public comment and perhaps further make modifications. We don't know what those modifications might turn out to be, or what the final rule may in fact look like.
Isn't there some responsibility on our part to look at it after the rule is finally promulgated, not get into the rule and change little accounting details here or there, but to say yes, this does or does not make sense in the overall scheme of financial information?
Why is that, in your view, an inappropriate review?
Mr. LEVITT. Mr. Chairman, I have learned long ago not to talk in absolutes because it is very difficult to tell what the future can bring. I guess that I would just measure the risks that I perceive in terms of having a vast marketplace, over $27 trillion in U.S. notional amounts of derivatives, basically unaccounted for. I view that as an enormous risk.
So I look upon a delay with great concern as a very, very considerable risk to America's investors.
Chairman BAKER. But my point is that the rule will not be implemented, if successfully adopted, nobody makes any further comment until January 1, 1999, at the earliest, at least, considerable time for review and comment about the proposed implementation. This would not be dilatory, it would not be toward the intention of delaying. It would simply be toward the purpose of understanding.
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And I certainly respect your capacity as Chairman of the SEC and your concerns about constraints on unbridled investment with unknowing participation by individuals, but Members of this subcommittee and, particularly, this subcommittee are equally concerned, because we also will be held accountable should events develop that are unfortunate.
We are just as committed to the transparency issue as you are. We just want to make sure that we understand the consequences of these actions. Taking some interim review process does not seem to me at all to put your ultimate goal at risk.
Mr. LEVITT. I believe that this process has been in the public arena for more than five years, that the process of exposure and public hearings and debate and dialogue and academic study and political input has been the most comprehensive and complete of any such process I have ever seen in my life.
That is not to say that any of us can look in the mirror and say that we are absolutely right. But I guess, in balancing the pluses and minuses and the risks and the rewards, I come out with a notion that America's investors are in jeopardy by not knowing the risks involved in terms of derivative exposure. And for us to delay beyond the one-year delay that we have already imposed, I believe would be unwise.
Chairman BAKER. Thank you.
Mr. Sutton, I am sorry, your title again, sir?
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Mr. SUTTON. Chief Accountant.
Chairman BAKER. And in your capacity, do you work on any day-to-day basis with FASB, or how do you mesh with their responsibilities?
Mr. SUTTON. The Office of the Chief Accountant is the primary adviser to the commission on, among other things, the oversight of private sector standard-setting processes, and that is within the AICPA and within FASB.
Chairman BAKER. In your capacity, do you have the ability to overrule FASB on any aspect of these rule promulgations, or no?
Mr. SUTTON. The commission obviously could. The staff does not have the authority to overrule.
Chairman BAKER. One last question, I know we have kept you at some length here.
Is it your opinion, Mr. Chairman, that the newly appointed commissioners will have an opportunity to vote on this issue before implementation, or not?
Mr. LEVITT. I am trying to think of what kind of vote there would be.
Chairman BAKER. Maybe that is a better question. Will there be any vote by the commission on this subject?
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Mr. LEVITT. I don't believe there will be. I certainly intend to discuss it with the new commissioners and get their input on this.
Chairman BAKER. If you would, after some determinations are made, just advise the subcommittee as to what you view the SEC's procedural steps with regard to implementation, so we understand how we are to proceed.
Mr. LEVITT. Absolutely. We would be glad to meet with you to discuss this after the new commissioners have phased in.
Chairman BAKER. Certainly.
Mr. Campbell, you have no further questions?
Mr. CAMPBELL. No, thank you.
Chairman BAKER. Thank you, Mr. Chairman, for your participation here today.
Chairman BAKER. I would ask our next witness, Governor Phillips, to come forward, please.
Governor Phillips, it is always a pleasure to have you appear before the subcommittee. As a former LSU student and instructor, it is always good to renew acquaintances. Certainly I do appreciate your willingness to be part of the hearing. Please proceed.
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STATEMENT OF HON. SUSAN M. PHILLIPS, MEMBER, BOARD OF GOVERNORS, FEDERAL RESERVE SYSTEM
Ms. PHILLIPS. Thank you very much, Mr. Chairman. I welcome the opportunity to discuss the Federal Reserve Board's views on proposed accounting standards for derivatives and risk management activities issued by the Financial Accounting Standards Board, or FASB. I would note we have a longer statement, and I am going to try to briefly summarize that statement. But I would appreciate the full statement entered in the record.
Chairman BAKER. Without objection, thank you.
Ms. PHILLIPS. Thank you.
In approaching this complex matter, it should be acknowledged up front that most responsible observers and market participants share an interest in improved accounting standards and disclosure of information that is useful and relevant to the broad range of users of financial statements. Thus, the desirability of meaningful disclosure is not the issue.
All would agree that enhanced financial disclosure and market transparency can lead to more efficient financial markets, more accurate pricing of risks, and more effective market discipline. A key question is how to ensure that accounting practices and techniques reflect and are consistent with how a business is run. Indeed, accounting methodology should measure the results of a business purpose or strategy and not be an end in itself. For example, in the case of a company that actively trades financial instruments or other products to profit from short-term price movements, such as a securities firm, reporting trading positions at fair values appropriately measures the success or failure of that business strategy, and market participants expect this reporting treatment.
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However, for many other types of businesses, such as a manufacturer or a lender that funds loans with liabilities of equal maturity, market value accounting in the primary financial statements may not accurately reflect business strategies or appropriately measure the firm's underlying performance and condition. In these cases, it is questionable whether there is widespread demand for market value accounting to become the basis for preparation of the primary financial statements.
Although the needs of financial statement users may vary, a critical function of financial statements is to reflect in a meaningful way underlying trends in the financial performance and condition of a firm. The application of market value accounting to business strategies where it is not appropriate, and particularly when applied on a piecemeal basis, may lead to increased volatility or fluctuation in reported results and actually obscure underlying trends or developments affecting a firm's condition and performance.
Requiring companies to adopt market value accounting where it is not consistent with their business strategies can cause them to incur significant costs to provide information that may not reflect in a meaningful way their underlying circumstances or trends in their performance. Moreover, from the standpoint of financial statement analysts and other users, having to make adjustments to remove the effects of this accounting volatility from income statements and balance sheets—volatility that is not consistent with a firm's risk positions—can also impose significant costs without offsetting benefits.
These problems can be minimized by placing market values in meaningful supplemental disclosures rather than forcing their use in the primary financial statements. Such an approach would give analysts the information they need, without imposing the broader costs of having to reverse or back out the effects of artificial volatility from the primary financial statements.
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We recognize the difficult task that FASB has in developing a standard that is acceptable to its many constituents. Thus, it is not surprising that their proposal raises a number of complex issues. For example, the proposal is likely to lead to increased volatility in income and stockholders' equity by companies that manage risk with derivatives. This volatility could be artificial due to the piecemeal approach of marking certain positions to fair value, but not all positions contributing to the risk.
A simple example might illustrate this concern. Assume a company's activities consist solely of lending long-term at fixed rates and funding those loans with variable rate deposits. I think we can all agree that this company has a significant exposure to interest rate risk. If the company does not manage its risk with derivatives, it would not be affected by the derivatives accounting proposal and would not report any volatility from fair value changes in its financial statements.
If, however, the company has a strategy to use derivatives to reduce its interest rate risk and move it closer to a match-funded position, the company may report greater volatility in income and stockholders' equity. Thus, the firm, in using derivatives, reduces its economic volatility, yet increases its accounting volatility.
More important, by taking a transaction level approach to hedging, the proposal would not describe well the efforts of more sophisticated market participants to hedge their risks on a comprehensive, portfolio basis. Thus, these firms would effectively be required to keep different sets of books, and their financial reporting may not be consistent with the derivatives' intended use.
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This leads me to conclude that the proposal could discourage or constrain prudent risk management practices that rely on derivatives. Furthermore, it may not improve transparency of financial information.
The proposal also introduces into the financial statements an untested hybrid approach for reporting loans, deposits, and other assets and liabilities being hedged. These hybrid amounts could differ significantly from—and potentially exceed—fair values. They may also be difficult to verify by auditors and examiners, thus reducing the reliability of amounts reported in the financial statements.
The proposed approach is complex and it may cause significant systems changes for institutions that hedge with derivatives. At the same time institutions are making these systems changes, they need to upgrade their systems to address year 2000 issues.
An alternative approach to accounting and disclosures for derivatives and financial instruments has received broad support from banking supervisors both domestically and internationally, as well as from some other major constituents. In this regard, the Basle Committee on Banking Supervision and the European Commission suggested this approach to the International Accounting Standards Committee on its project on financial instruments.
Under this approach, FASB would enhance the current historical cost-based financial reporting framework by issuing a derivatives accounting standard that is based on the best current accounting practice for derivatives; and second, supplement the historical cost-based statements with expanded disclosures by larger market participants of financial statements based on fair values, including the fair value of derivatives and other financial instruments.
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There may also be other acceptable ways of addressing the many concerns expressed by commentators on the FASB proposal. For example, FASB could in the near term focus on improvements to existing derivative accounting practices under the historical cost framework. Alternatively, FASB could defer the effective date of the proposed standard to provide more time for constituents to address implementation issues and make systems changes.
In the end, it is the responsibility of the FASB, SEC and the IASC to find the best practicable solutions for accounting and disclosures for derivatives and other financial instruments.
We are glad to be able to participate in the public comment process and look forward to doing so in the future.
Chairman BAKER. Thank you, Governor. Just to emphasize, although it is in your statement this morning, that you not only speak in your capacity as a Governor, you speak for the board on this issue, and this is a policy position of the Federal Reserve Board?
Ms. PHILLIPS. Yes, sir, that is correct.
Chairman BAKER. I think it important to note, frankly, this subcommittee has over time given great deference to the Federal Reserve's positions, and even though our debates over financial modernization have not always gone smoothly, we have appreciated the insight and professionalism that the Federal Reserve brings to these debates.
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I was interested in, particularly, Mr. Levitt's explanations as to the possible impact of these rules; and Mr. Campbell, who had to leave just a moment ago, his example with regard to a specific transaction where the interest rate risk hedge was involved and that the reporting of the accounting requirement does not in fact match well with the economic reality.
It appears that the implementation of the rule is much like our own budget accounting here in the Congress, that something costs money because they say it costs money, not because in fact it does. If you take the proposal in the current debate over highway spending, in year one, we are going to spend X number of dollars, but it happens to be more than we are going to spend in years two through six. Under the results, you take the first year's expenditure, X, and multiply it by 6, and that is the budget cost for the expenditure without regard to the economic reality.
It appears what we are getting here is a congressional budget rule applied to the financial marketplace, that you are attempting to get clarifying information, but we in reality are going to get economic clouding.
It was suggested to Mr. Levitt that some in the marketplace, in light of this, may choose either not to engage in the hedging instruments because the reality is, the accounting consequences and the volatility that affords may be more costly than the risk one runs by not hedging against the principle risk.
Do you agree with that assessment?
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Ms. PHILLIPS. Yes, sir. That is precisely one of our concerns. We are somewhat concerned that firms, for example, can engage in very similar kinds of transactions, one involving a derivative, another involving a cash instrument, but they would, in this example, end up with very different accounting treatments, and yet the economic purpose of what they are doing is the same.
We think that firms may opt for the less complex accounting approach, an historical approach, and avoid the use of derivatives.
That was one of the concerns, and we did communicate that to the FASB.
Chairman BAKER. In your opinion, are the current disclosure mechanisms that we now see on the financial statement adequate for an informed reader of the financial statement to determine financial condition, or do you share the concern that the derivatives risk which is inherent in the portfolio is not appropriately disclosed, and therefore, investors cannot make prudent decisions?
Ms. PHILLIPS. Well, first of all, there is not a lot of information that is disclosed under current accounting practices. It does mean you may have to go through the footnotes to find some of this information. But there is a good deal disclosed.
Certainly in the case of banks, as you well know, we have made significant changes to our call reports to make additional information available, so there is a good deal of public information made available.
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To get back to the first part of your question, though, having to do with whether or not the current disclosures are adequate or the current stream of information is adequate, we do believe that there are some improvements that can and should be made. As part of Chairman Greenspan's suggestion, we think that additional guidance would be necessary if the FASB were to adopt the approach that Chairman Greenspan suggested. This would take some additional guidance.
There are some kinds of derivatives that do not get the same treatment, so I do think that there would need to be some clean up of existing standards.
We do think, for the larger institutions that are engaged in various kinds of derivatives activities, that the supplemental statements that provide additional information are appropriate. What we are concerned about is applying the same standards to everyone, which will be quite costly for the firms that only use derivatives occasionally, and yet they would be subject to this more expensive cost disclosure system.
Chairman BAKER. As to difficult choices that the Congress may face on this issue. Would we be better advised not to take the step forward at all that FASB is proposing, in light of what would be potentially negative consequences? Better advised to work through the comment period and try to modify the rules in some form or fashion through suggestions from the Federal Reserve or through the subcommittee's own recommendation? Or is it better to see the rule be promulgated, handed off to the SEC, and simply try to postpone the effective date to give firms two years instead of one?
Ms. PHILLIPS. Well, of course, we are at midstream in the process at this point, and the comment period has not yet closed. We really do not know what kind of final adjustments the FASB would make even if they were able to meet their goal of having a standard by the end of this year. So, it seems to me that we should wait and see what they come up with.
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Chairman BAKER. I only ask that question in light of Mr. Jenkins' earlier response to my question, ''Do you intend to modify the rules?'' He said, ''Perhaps.'' I got the clear impression there would be marginal modifications at best.
Ms. PHILLIPS. I would certainly hope, based on the comments that various interested parties submit, that there would be a review again of the proposed standard. I don't think we know enough at this point to make that kind of assessment. But I do want to state very clearly, we believe very strongly that the FASB has a difficult task, and that they are the ones that are best charged with trying to come up with the best professional accounting standards.
Chairman BAKER. But if the rule, as we now understand it, that is being proposed, were to be adopted, in your view—maybe not even speaking for the board, but just in your professional view, it would result in the clouding of information as opposed to the clarity of information?
Ms. PHILLIPS. I believe that that is the case, yes.
Chairman BAKER. Thank you very much. I appreciate your willingness to appear here today. I have been notified other Members have questions to forward to you in writing pursuant to the hearing, and we will appreciate your response.
Ms. PHILLIPS. Thank you very much, Mr. Chairman.
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Chairman BAKER. Thank you for participating.
I would also like to ask our next panel to come forward.
I would like to welcome this panel, and we appreciate your patience.
First, I would like to recognize Mary Barth, Associate Professor, Graduate School of Business, Stanford University.
STATEMENT OF MARY E. BARTH, ASSOCIATE PROFESSOR, GRADUATE SCHOOL OF BUSINESS, STANFORD UNIVERSITY
Ms. BARTH. Thank you. Mr. Chairman, Members. Thank you for inviting me to testify today on the FASB derivatives proposal. I base my comments on my experience as a member of the Financial Accounting Standards Advisory Council and my academic research, primarily addressing financial accounting questions in the context of the capital market.
I believe the FASB's proposal for derivatives is a step forward in financial accounting and reporting. I also believe the proposal should be issued as a standard without formal reexposure, which would unduly delay provision of this important information to investors and other financial statement users.
In my view, recognizing derivatives as assets and liabilities at fair value is the most important improvement the FASB's proposal makes to current accounting. Currently, financial statements largely ignore the economic effects of these instruments. Recognizing derivatives in financial statements, including the income statements, should provide investors and other financial statement users with better information for their investment and capital allocation decisions.
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Most derivatives are absent from balance sheets, not because they have inconsequential economic effects, but because they require no upfront cash payments. Long ago, accountants determined that basing financial statements only on cash transactions resulted in omitting important information. The derivatives proposal is just another in a series of standards designed to achieve the FASB's objective of recognizing all financial instruments at fair value.
Because the economic effects of derivatives are large and the amounts recognized in the financial statements often are zero, derivatives represent assets and liabilities whose financial accounting deserves timely corrective action by standard-setters.
Some argue that a gradual move to fair value accounting results in financial statements that are uninformative at best and misleading at worst. It is important to recognize that using fair values to determine some, but not all, accounting amounts is not new with this proposal.
I believe piecemeal implementation of fair value accounting is prudent and necessary. Waiting for comprehensive fair value accounting would unnecessarily deprive financial statement users of information, potentially resulting in misinformed decisions.
Even fair value accounting for all financial instruments will not eliminate the complexities of hedge accounting. If nonfinancial assets or liabilities, not recognized at fair value, are involved, or the hedge transaction is only expected and is not even a firm commitment, issues of hedge accounting remain.
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I believe the FASB's proposal will improve hedge accounting. First, it requires earnings to reflect any actual hedge ineffectiveness. Current accounting permits management to assert a hedge is effective, thereby eliminating any earnings effects.
Second, many hedging instruments and hedged items currently are recognized on the balance sheet at historical cost. Under the proposal, not only will derivatives be recognized at fair value, but also more nonderivative instruments will be recognized at amounts closer to fair value.
It is also important to note that firms that use derivatives effectively and for sound economic reasons have little to lose and potentially much to gain by providing investors with more information about their derivatives activity. In particular, enhancing investors' understanding about derivatives' use should reduce the information risk premium investors demand and, thus, can reduce firms' cost of capital. Thus, if anything, increased transparency about derivatives should enhance, not hinder, management's ability to use derivatives to manage risk.
Using derivatives to hedge anticipated transactions can be sound risk management. However, the balance sheet focuses on reflecting economic values of the firm's existing assets and liabilities. These include derivatives, but do not include realized losses or gains or the expected benefits of future transactions.
Some argue that the proposed accounting for hedges of anticipated transactions would result in increased equity volatility. This likely is true. However, the increased volatility results from the economic effects of the firm's activities. The lower equity volatility under current accounting rules is artificially created by accountants, by ignoring the economic effects of derivatives.
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I believe the FASB has provided its constituents with ample opportunity to express their views on this proposal. I encourage them to issue the standard as soon as practical after they evaluate and act on the next set of input they receive. In my view, reexposure would only delay getting into the hands of investors the additional information relating to derivatives' use and hedging activities. I believe this is too high a price to pay for another round of fine-tuning the details.
The FASB has been criticized for acting too quickly on derivatives. On other occasions they have been criticized for acting too slowly. In my view, the FASB's handling of the derivatives project reflects their commitment to provide guidance on a timely basis on important and technically difficult issues. They should be commended, not criticized.
I encourage this subcommittee not to impede the FASB in improving information about derivative financial instruments available to participants in our capital markets. Thank you.
Chairman BAKER. I appreciate your comments.
The next witness is Roger Trupin, the Comptroller for Citicorp. Welcome.
STATEMENT OF ROGER W. TRUPIN, COMPTROLLER, CITICORP
Mr. TRUPIN. Thank you, Mr. Chairman. My name is Roger Trupin. I am a Certified Public Accountant with 35 years of public and private accounting experience, and I serve as Comptroller of Citicorp, a participant in the global derivatives markets.
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We provide the derivatives for our customers and use them ourselves in the management of our own risk exposure. Based on this experience, we are opposed to the accounting rulings proposed by the FASB and we appreciate this opportunity to bring our concerns to your attention.
I would like to talk very briefly about what this issue is and is not. This is not about some unfilled need for transparency to enable investors to see what is going on. The fact is that there is extensive disclosure and all derivative transactions are recorded following very sound accounting methods, accounting that has evolved to meet the needs of investors.
Also, the issue is not about formalizing a rule calling for the fair values of derivatives to be reported even more prominently. I am not aware of anyone would who would object to that.
This issue is about the volatility that would be artificially imposed on income and capital, and about the need for rules for companies to report the economic realities of their risk management strategies.
The fact is that the proposed rule drastically changes the way derivatives are presented in the financial statements, but the proposed rule is so restrictively written that many, possibly most, of today's prudent risk management strategies will have to be reported in the financial statements as if they are bets, rather than hedges.
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The issue is also about the impact of the proposed rule on costs and competitiveness.
The proposed rule is very complex and often unintelligible, even to experts. It will add a significant layer of costs to be borne by U.S. business, costs that inevitably find their way into the pricing and availability of many consumer products and services.
The proposed rule will require the overhaul of systems and controls that are already stressed by the need to prepare for the year 2000 and the single European currency.
Sadly, this issue comes down to the FASB rulemaking process. It has simply failed to produce a workable and useful rule.
Over the years, we and others have had many disagreements with the FASB over accounting rules, and they have made their share of mistakes. A number of these, such as income taxes, loan impairment, asset transfers, there has been a need for significant amendment or delay.
This derivatives issue is clearly a mistake in the making. Here the stakes are higher. Serious public policy concerns have not been evaluated by the FASB, despite six years of study and over 100 public meetings. Senior officers of major corporations have written letters, but their concerns have not been seriously considered. The Chairman of the Federal Reserve has written of his concerns and has proposed an alternative solution, but his views have been put aside.
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There is a rising tide of concern from finance and accounting professionals, but the FASB has responded with public statements that make it clear that there is no intention to reconsider its decisions.
Derivatives, like other financial instruments, require sound management, sound controls, effective disclosure and good, consistent accounting practices. That is what we have today, and that is what the FASB proposal places at risk. For what end? The November 1996 GAO report reviews the highly publicized derivatives blowups of the early 1990's—Barings, Orange County and the like—and the report makes it clear that derivatives themselves are not the culprit, and neither is derivatives accounting.
When you look at the facts, you will see this FASB proposal, with all of its burdens, would not have prevented imprudent risk-taking or the falsification of accounts. Prevention requires strong risk management and controls.
The FASB proposal would not shed any new light after the fact, because full fair value data on derivatives in all financial instruments is now prominently disclosed. What we need now is a solution that avoids the potentially damaging effects of the FASB proposal.
One alternative path was recommended by Chairman Greenspan in his July letter. I, for one, would be willing to consider it or any other solution that would avoid the distorted effects on income and capital, satisfy public policy concerns, and protect consumers.
Accounting rules should serve investors and give us efficient and effective capital markets. We should accept nothing less. Thank you.
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Chairman BAKER. Thank you very much, Mr. Trupin.
Our next witness is John Thornton, Chief Financial Officer of Norwest Corporation. Welcome.
STATEMENT OF JOHN T. THORNTON, EXECUTIVE VICE PRESIDENT AND CHIEF FINANCIAL OFFICER, NORWEST CORPORATION
Mr. THORNTON. Thank you, Mr. Chairman. As you have said in your introduction, I am John Thornton, Chief Financial Officer of Norwest Corporation. We are headquartered in Minneapolis, Minnesota. We are an $83.9 billion bank holding company. We do business in all 50 States, Canada, the Caribbean and Central America.
In the brief time allotted to me today, I would like to make two points. First, the proposed accounting rulings will not afford the precision and accuracy and reported results that the FASB would like to suggest. Second, its introduction may well result in economic costs to consumers. Let me talk about the potential costs to consumers first.
Norwest is the largest originator of residential mortgages in the country. We originate over $50 billion worth of mortgages annually. We are also the largest mortgage servicer, servicing approximately $200 billion worth of mortgages.
In both of these business areas, our customers, the consumer, have options which are valuable to them and which put Norwest at risk to incur costs. We, Norwest, use derivatives to hedge against these potential costs.
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In the mortgage origination area today, consumers typically have a right to ''lock in'' interest rates existing at the time of application. This lets them know exactly what their monthly payment will be and affords them the opportunity to capture a low interest rate during interest rate cycles. If rates go up prior to the closing, the customer is protected. If rates go down prior to the closing, he or she can use another lender where they might have applied on a floating basis, or they can reapply at the lower rate.
Today, Norwest protects itself against this potential loss in giving customers this option by hedging with derivatives. Hedging in this area is part science and part art. The extent of customers deciding whether or not to proceed to close will be impacted not only by a change in interest rates, but the extent of change, consumer confidence, the availability of mortgages, and a number of other areas.
FASB-induced volatility in reported earnings or comprehensive earnings could cause lenders to stop giving customers the lock-in rate capability or could lead to a charge to customers for that right.
Similarly, customers have the right to prepay their mortgages at any time. In times past, that right was restricted by the imposition of prepayment penalties. Today, we have found a better way; mortgage servicers can economically protect their servicing assets by hedging with derivatives and give the customer this added benefit.
Norwest has approximately $3 billion on its balance sheet for mortgage servicing rights. It represents value to be realized from performing future servicing activities. Here, too, we protect ourselves by hedging with derivatives, and the customer benefits by no longer being burdened by prepayment penalties. They have the ability to refinance if interest rates decline, and to do so in modest interest rate declines.
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This brings me to the point concerning precision and accuracy in reporting results under the proposed FASB. In the cold clinical calculable world of FASB, both the derivative and the item hedged are susceptible to crisp determination of value. The instances I have cited are filled with subjectivity and any overall point-in-time appraisal will be imprecise.
Let me remind you of the old adage, ''There is no perfect hedge.'' Under the FASB rule, that seems to be overruled, and all hedges are expected to be perfect. Under the current accounting model, the actual realized results in my examples would be reported in the income statement in a very short time. The time from application to closing to selling a loan in the secondary market takes approximately 4 to 6 months, and the results are thereby known. That transaction is replaced by another, which is hedged, and the process is repeated over and over again.
In servicing, hedges are renewed and replaced with their actual cost being amortized over benefit periods. Any attempts at overall valuation would result in recognizing volatility, which in most instances will not be realized on an actual basis. Rather than approving accuracy of reported results, I believe the proposed FASB will lessen accuracy, increase volatility, and also increase costs to consumers.
Thank you, Mr. Chairman.
Chairman BAKER. Thank you, Mr. Thornton. I appreciate your time and interest in being here.
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Let me advise my next three witnesses, I have got a difficult choice to make here. I want you to make it, as opposed to me. We have one 15-minute vote and a series of 5-minute votes thereafter. My guess is that we would be detained on the floor 30- to 45-minutes. Now, I hate to suggest that you sit here and wait. The only other option that would be available to us is if you would like to summarily proceed and submit your statement for the record, I would be happy to do that and maybe give you a minute or so apiece, as long as I can get out of here with 3 minutes to go.
I have just been advised there are 14 votes. That may help change your position a little bit, 14 votes. How about we go for close to a minute, a maximum of 2, and that will get you out of here and you can go back to normal conduct of business.
Ms. Bies.
STATEMENT OF SUSAN SCHMIDT BIES, EXECUTIVE VICE PRESIDENT, RISK MANAGEMENT, FIRST TENNESSEE NATIONAL CORPORATION
Ms. BIES. All right. I guess if I have got one minute, the key issue I want to point out is our concern at First Tennessee that the new accounting is not reflective of what we do to meet our customer needs.
First, we know that our customers are going to want to do long-term fixed rate loans when rates are low, and that is exactly when they are going to want to have deposits that are short, so they can get higher interest rates later. And because of that, it puts the bank at risk.
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This new accounting that is being proposed is going to mean, depending on the way we hedge the risk, we will have different accounting results. Whether we hedge the loan side or we hedge the deposit side, we will have inconsistent accounting for the same economic event, which doesn't make sense.
The second point is, as a risk manager, when you look at all the publicized events that have happened in the past that have been ''derivative'' surprises, they have been due to poor risk management practices and not accounting. Risk management has come a long way in the last three to four years. There now exist readily-available best-practice benchmarking risk practices. What happened in the past surprises were failures in audit and internal controls, and the public accounting firms share that blame. We now all need to address audit and control issues, and you can't do that through accounting.
Finally, in terms of the implementation date of January, 1999, we as banks have to get through the year 2000 computer compliance issue by next year-end. That means, for some of us, we are totally revising all of our loan and deposit systems. It is going to take a while to understand this new accounting.
If we could hire a programmer, we would be ecstatic today. We don't know if we can hire somebody to get this accounting done on top of these software changes in such a short time frame.
Thank you.
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Chairman BAKER. Thank you very much.
Mr. John Brennan, I apologize for our short time. I know your position on the issue. I want to make sure it is fully aired.
Mr. BRENNAN. That is fine.
Chairman BAKER. President and CEO of Vanguard.
STATEMENT OF JOHN J. BRENNAN, PRESIDENT AND CEO, THE VANGUARD GROUP
Mr. BRENNAN. I will make four quick points.
First, we represent millions of individuals who invest over $300 billion in the Vanguard mutual funds. We feel very strongly about this issue and about disclosure in general. We are a major investor in banks, significant holder of over $10 billion in bank stocks.
We are a lender to banks through our money market and bond funds, as well, so we again have a very strong interest in this and a strong opinion about it.
The second point I would make is that we are also a very heavy user of derivatives in our own funds for liquidity purposes, for risk management purposes and so on. And in the fund industry, we have lived by mark-to-market rules. We believe it is the most effective way to manage an investment portfolio and, frankly, to provide the best information and sense of risk in our portfolios to our clients.
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So, we live by these kinds of rules; we think it is an effective way for all financial institutions to live.
The last two points really are these. We understand that no new rules, no accounting rules, are perfect; but, as investors, we believe that more information, particularly more information that discloses practices that have to do with the risk characteristics of companies with which we invest, is better.
Are they perfect? We don't think so, but we think the new FASB rules are a great step forward.
Finally, it is our opinion that the process, as it has played out over several years—and, I guess, with 14 or 15 days to go from a comment period standpoint—is fair and valid, and we would recommend that further delay would be disadvantageous to our investors and to us as investors.
Thank you.
Chairman BAKER. Thank you.
Mr. David Berry, Director of Research, Keefe, Bruyette & Woods, Inc.
STATEMENT OF DAVID S. BERRY, DIRECTOR OF RESEARCH, KEEFE, BRUYETTE & WOODS, INC.
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Mr. BERRY. Thank you. My perspective is as a securities analyst. I have been a bank analyst for 12 years and have run the research department at KBW for the last 5. We are a firm that has been around for the last 35 years, specializing in bank stock analysis and underwriting as a broker/dealer.
As a user of financial statements, the person for whom FASB evidently believes it is working, let me be real clear: Financial statements are tools. They are the beginning of analysis, not the end. We understand that there are limitations to them and we do not expect them to contain the whole truth. It is, again, the beginning of analysis.
Let me also be clear that, as an analyst, my desire for additional information is usually insatiable. My concern is, the FASB proposal, by adopting a hybrid approach of actually valuing individual assets, the mixture of historical cost and fair value, by doing very strange things in the proposal, where the carrying value of assets or liabilities will be more volatile if hedged than not hedged, will actually corrupt the balance sheet and income statement as we know it, and basically limit the usefulness of the financial tools which I am used to using, in an effort to get at truth. The result will be more obfuscation, not more clarity.
The Federal Reserve's proposals for additional disclosure, perhaps separate from the balance sheet and income statement, seem to make a lot of sense to me. Again, more information is helpful. I think the FASB proposal is one that will actually reduce the amount of information I need to make the kind of decisions I need to make.
Chairman BAKER. I thank each of you very much for your courtesies. Let me summarize quickly by saying, obviously I have not had an opportunity to counsel with Members, but I do have some personal views as a result of the hearing today.
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First, within the industry itself, the AICPA asking not for modification, but simply a delay to accommodate implementation, is a sign to me that some review would not be untoward or ill-advised.
Second, the dispute as to appropriateness between Federal regulators further warrants some concern on my part. I don't hold one higher than the other, but I think the Federal Reserve and FASB certainly should be able to get on a page of some mutual agreement.
Third, I think that the way in which this proposal has been molded, particularly with Mr. Levitt's involvement in the public sphere, is to some degree limiting a true response from the market participants.
So, I will discuss and pursue at least some review opportunity, if nothing more than just an extension of the public comment period beyond October 14, but at least give us the opportunity to fully comprehend the consequences of our actions.
With that, I want to thank all of the participants for your courtesy and time.
The hearing is adjourned.
[Whereupon, at 1:15 p.m., the hearing was adjourned.]