The Price of an Uncertain Promise: Fair Value Accounting and the Shaping of Bank Counterparty Risk Valuation Practices

Abstract

How did the adoption of fair value accounting by the FASB shape the financial modelling practices used by market practitioners? Drawing on documentary sources, ethnographic fieldwork, and 52 interviews with financial economists and market participants, this article addresses this question by tracing the development and adoption of the mathematical models and associated infrastructures that derivatives ‘dealer’ banks use to assign value to the counterparty risk embedded in the ‘over-the-counter’ derivatives contracts they trade. Rather than reflecting a pre-existing consensus on the part of financial market participants in favour of valuation practices drawn from financial economics, this article suggests that the switch to fair value actively shaped the financial modelling and risk management practices used by dealers to value and manage this risk. While a number of material and institutional factors shaped the adoption of these practices, the switch to fair value ultimately ‘tipped the balance’ in favor of a particular set of practices that were preferred by a minority of investment banks. In explaining the development and adoption of banks’ counterparty risk modelling practices, this paper develops a hybrid theoretical approach that combines organisational institutionalism’s focus on meso-level field dynamics and the social studies of finance’s focus on materiality.

Funding Value Adjustments

“…SeeModigliani and Miller (1958).18 For DVA and CVA analysis, see, for example,Sorensen and Bollier (1994),Duffie and Huang (1996), andGregory (2015) Spears (2017). discusses the history of DVA and CVA adjustments.…”

Funding Value Adjustments

“…SeeModigliani and Miller (1958).17 For DVA and CVA analysis, see, for example,Sorensen and Bollier (1994),Duffie and Huang (1996), andGregory (2015) Spears (2017). discusses the history of DVA and CVA adjustments.…”