Fair Value Accounting and Financial Stability

Abstract

Market prices give timely signals that can aid decision making. However, in the presence of distorted incentives and illiquid markets, there are other less benign effects that inject artifi cial volatility to prices that distorts real decisions. In a world of marking-to-market, asset price changes show up immediately on the balance sheets of fi nancial intermediaries and elicit responses from them. Banks and other intermediaries have always responded to changes in economic environment, but marking-to-market sharpens and synchronises their responses, adding impetus to the feedback effects in fi nancial markets. For junior assets trading in liquid markets (such as traded stocks), marking-to-market is superior to historical cost in terms of the trade-offs. But for senior, long-lived and illiquid assets and liabilities (such as bank loans and insurance liabilities), the harm caused by distortions can outweigh the benefi ts. We review the competing effects and weigh the arguments.

The crisis of fair-value accounting: Making sense of the recent debate

“…There are essentially two arguments why FVA can contribute to procyclicality: one in booms and one in busts. 8 The first argument is that FVA and asset write-ups allow banks to increase their leverage in booms, which in turn makes the financial system more vulnerable and financial crises more severe (e.g., Persaud, 2008;Plantin et al, 2008b). 9 In contrast, HCA prohibits asset write-ups in booms and creates "hidden" reserves, which can be drawn upon in times of crisis.…”

Bank procyclicality and output: Issues and policies

“…16 Thus, the fair-value accounting method leads to an endogenous volatility of prices (Platin et al, 2008a;2008b), making procyclicality endogenous. Moreover, the volatility caused by this method may increase because of estimation errors, inherent volatility and the use of the mixed attributes model (i.e., the application of fair-value accounting to some instruments and amortized cost accounting to others) when preparing financial statements, thus reducing the net effect (Barth, 2004).…”

An Empirical Study on Value Relevance of Fair Value: Based on the Data of Financial Industry and Manufacturing Industry in China

“…Plantin et.al. [14] considered that under fair value accounting, asset write-ups allow banks to increase leverage in period of economic expansion, which make the financial system more vulnerable and bring volatility and contagion to financial market. Adrian and Shin [15] used the sampling data of American financial institutions and found that financial institutions using fair value could suffer pro-cyclical effects, which may bring more risks to banking and capital market.…”

“…Under fair value accounting, the value of asset is allowed to be written up and written down; as such, when the market is preposterous, the market value of asset tends to increase. Asset write-ups enable companies to increase leverage, which introduces high risks to corporate finance [2]. However, when it comes to macroeconomic depression, fair value write-downs magnify losses and cause panic among investors.…”