Fair Value Accounting and Financial Stability

Guillaume Plantin (1, 2) , Haresh Sapra (3) , Hyun Song Shin (4)

1 London Business School
2 Tepper School of Business
3 University of Chicago
4 Princeton University

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 artificial 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 financial 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 financial 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 benefits. We review the competing effects and weigh the arguments.

Keywords: Financial stability; Market prices; Bank policy; Liquid and illiquid markets

Domains: Humanities and Social Sciences; Economics and Finance

Guillaume Plantin, Haresh Sapra, Hyun Song Shin. Fair Value Accounting and Financial Stability. Financial Stability Review (FSR) Banque de France, 2008, Special Issue on Valuation (12), pp.85 - 94. ⟨hal-03459862⟩