The recent Silicon Valley Bank debacle and the ensuing financial crisis have spotlighted the role of accounting practices in exacerbating market turmoil. Backed by research, we assert that one valuation method contributed to SVB's failure, whereas another method could have saved it.
Mark-to-market accounting, also known as fair value accounting, mandates reporting current market prices of financial instruments — primarily long-term treasuries in the case of SVB. While aiming to provide transparency, this rule can have unintended consequences: spooking investors and depositors during turbulence, such as today's toxic mixture of inflation, almost-recession, and illiquidity. As interest rates rise, long-duration fixed-income securities' values tumble, giving rise to substantial unrealized losses. This happened in SVB and likely will occur in many other financial institutions.
The result: Scared depositors withdraw cash, and alarmed investors dump their securities holdings. What follows is, by now, the familiar downward spiral. Admittedly, other factors were at play in the SVB case: a flight of deposits to higher earning assets, venture capital illiquidity, etc. However, it is hard to ignore the role of scary losses in this collapse.
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In the case of SVB, the bank's adherence to fair value accounting has likely contributed to its failure. As the market values of its assets plummeted, SVB was forced to report substantial write-downs, which weakened its balance sheet and likely triggered a loss of confidence among investors. Along with other events, these unrealized losses eventually led to the bank's collapse and reinforced the negative perception of financial institutions during the crisis.
In retrospect, it is worth considering whether adopting an alternative valuation method, such as discounted cash flow valuation, could have provided a more stable long-term value for SVB and reduced the risk of failure.
DCF quantifies investments using the present value of their expected future cash flows, providing a stable valuation basis, especially during market volatility periods. By factoring in the time value of money and the risk associated with future cash flows, DCF accounts for the uncertainties inherent in financial markets. It would have insulated SVB from the short-term fluctuations in market prices, reducing the need for significant write-downs that ultimately weakened its balance sheet. It would have instilled greater confidence among investors, reducing the likelihood of losing confidence and the subsequent downward spiral.
We can't turn back the clock to know whether adopting DCF valuation would have saved SVB. However, the Financial Accounting Standards Board should consider the implications of its accounting practices and strive to develop more robust methods for valuing assets in an increasingly uncertain world.
