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Seeking fair value in government accounting

Governments around the world are piling on financial risk. At what cost? They have no idea.

November 26, 2014

MIT Sloan finance professor Deborah Lucas

MIT Sloan finance professor Deborah Lucas

Government accountants worldwide are systematically underestimating the cost of their own credit support, allowing an unseen buildup of risk and a less-than-optimal allocation of public resources, according to research from MIT Sloan finance professor Deborah Lucas.

In a study published in July in Economic Policy, Lucas examines the credit cost analysis practices of countries in the Organization for Economic Cooperation and Development. The paper is titled Evaluating the Cost of Government Credit Support: The OECD Context.

“Governments are absorbing enormous amounts of financial risk without acknowledging the full costs,” Lucas said in an interview. “After the financial crisis, most policymakers were very happy that they’d put the genie back in the bottle. But the question is ‘If governments keep on putting genies back in bottles, will there come a point where they run out of risk-bearing capacity?’”

A root cause of the distortions is a widespread misconception about the government’s cost of capital—the return it would have to earn on an investment to break even. Governments view their cost of capital to be their own borrowing rates and by doing so fail to recognize the cost of the equity capital that must be provided by taxpayers, Lucas said. As a result, many risky investments that private industry would see as losers are deemed profitable in the eyes of government accountants.

“This paper really makes a compelling case against using the risk-free rate [and for an approach based on] fair-value accounting,” David Scharfstein, a professor of finance and banking at Harvard Business School, said at the MIT Center for Finance and Policy conference in September. Scharfstein said government use of risk-free borrowing rates results in over-reliance on credit support, over-reliance on government credit as opposed to private credit, and a build up of risk on government balance sheets.

What Europe and Tennessee have in common

In each of the three case studies examined, Lucas estimates how much the entity in question is underestimating its costs and the potential downside of doing so.

  • At the European Bank for Reconstruction and Development, which provides loans, equity investments, and guarantees for developing market economies, member countries have committed about 23 billion euros of callable capital. The bank can demand the callable capital should its reserves become insufficient to cover its obligations to debt holders.

    Committing callable capital is costly to member countries because if it is called it will never be returned. Nevertheless, most countries record no budgetary cost for making those promises. Lucas estimates the unrecognized cost to members of callable capital over 20 years to be about 7 billion euros. The U.S. is the largest shareholder of the bank.

    The bank’s view of its own profitability is also distorted by treating taxpayer capital as free. By Lucas’s estimates, its profits are overstated by about 700 million euros a year.

  • At the Tennessee Valley Authority, the federally owned utility for the mid-South, physical assets like dams and power plants are funded through earnings and debt issuance. The debt carries a low interest rate because of an implicit guarantee from the government, Lucas said. But when taxpayer backing is considered, the utility moves from appearing profitable most years to showing a substantial economic loss, her work shows.

    “When the government is making physical or financial investments and it’s evaluating whether something is a go or a no-go, it’s going to wind up saying ‘Go’ more often when it’s not recognizing its full cost of capital,” Lucas said. “What that leads to is systematic over-investment by the government.”

    “If costs are invisible, they’re ignored,” she said. “And that creates serious distortions in how society allocates resources.”

  • The European Financial Stability Facility was created in 2010 as a rescue mechanism for OECD member nations following the beginning of the Eurozone crisis. It is funding recovery programs for Greece, Portugal, and Ireland, while also providing some assistance to Spain and Cyprus. The facility’s ability to cheaply borrow large sums from international capital markets rests on the 700 billion euros of capital and callable capital it has from member countries. Given the nature of the risk, calls on capital are expected to be infrequent but potentially huge. The unique nature of crisis events makes it hard to precisely measure the fair value cost of the exposure, but Lucas estimates it to be in the range of 20 to 80 billion euros depending on the likelihood and severity of an individual crisis.

    None of that cost appears on the member states’ books.

    “It’s not even on the radar,” Lucas said. “If governments were required to estimate guarantee costs, it would make them more aware of their exposures.”

What to do? Lucas advocates that governments adopt the accounting valuation method known as fair value to fully disclose the costs of credit support activities.

“Governments increasingly require fair value disclosures from private financial institutions because it is considered to be the most accurate approach,” she said. “They should hold themselves to the same high standard.” There are practical challenges to implementation, and political resistance to disclosing higher budgetary costs since in almost every case the change will show that government support is more expensive than it is currently understood to be.

But there is also some political will for greater transparency, Lucas said, pointing to legislation that has passed the U.S. House of Representatives that would implement fair value accounting for U.S. credit programs.

A reason for research and education

Helping government analysts and policymakers evaluate and communicate the costs and risks of government credit support would also require more financial education for public sector employees than what is typical today. That sort of education is part of the mission of the MIT Center for Finance and Policy, launched this year to address the gaps between the public and private sectors in their access to financial education and the focus of academic research.

“It’s very much in line with MIT’s tradition of promoting research that offers new ways to tackle practical problems that are technically challenging, and providing that information in a way that is credible and unbiased,” Lucas said.