Both Fair Value and Historical Cost Accounting Contribute to Systemic Risk in the Financial Sector

Although fair value accounting was blamed by some as the primary cause of the 2008 financial crisis, a new study from the RAND Corporation finds that this was probably not the case.

Nevertheless, policymakers should be aware that both fair value and historical cost accounting sometimes can produce misleading information, resulting in both institutional and systemic risk.

Fair value accounting, sometimes referred to as “mark-to-market,” is the practice of banks and other financial institutions updating the valuation of assets or securities on a regular basis — ideally, by referring to current prices for similar assets or securities. With historical cost accounting, on the other hand, banks and other financial institutions record the value of an asset at the price at which it was originally purchased.

“The key question is not whether fair value accounting or historical cost accounting is better, but instead, how do you ensure that each is implemented properly?” said Michael Greenberg, lead author of the study and director of the RAND Center for Corporate Ethics and Governance. “When implemented poorly, both methods can be associated with systemic risk to the financial system.”

The study from RAND, a nonprofit research organization, examines and clarifies the relationship between these two accounting approaches and the risks to the financial system. It examines the savings and loan crisis of the 1980s, the less-developed country debt crisis of the 1970s and the empirical literature pertaining to the 2008 financial crisis. The study also explores insights about systemic risk that can be gleaned from better understanding the accounting approaches.

Greenberg said examining both accounting methods is important because they establish a basic information framework for financial disclosures, on which investors, regulators and financial institutions all rely upon. In addition, the accounting standards are deeply tied to the oversight of banks and to assessing the adequacy of bank capital reserves.

In the immediate aftermath of the 2008 financial crisis, conflicting arguments were made about the contributions of valuation approaches in triggering the crisis. In particular, some experts suggested that fair value accounting forced banks and financial institutions to write down the value of assets on their books in a self-perpetuating spiral of devaluation, panic selling and loss of liquidity.

Greenberg and his colleagues reviewed the evidence from all of the major empirical studies of the 2008 crisis undertaken to date, and concluded that fair value accounting was probably not a primary driver of the 2008 crisis.

Instead, the RAND team spotlighted a somewhat different lesson about risk and approaches to financial asset valuation. Although both fair value and historical cost accounting approaches can provide useful information when applied rigorously, each can produce misleading information when implemented poorly and when oversight is weak. In turn, poor valuation practice can contribute to the accumulation of risk, both within institutions and systemically across the financial sector, Greenberg said.

Improving the quality of both fair value accounting and historical cost accounting information in financial statements should be a priority consideration for policymakers, Greenberg said. Policymakers should consider new steps to strengthen institutional governance and control mechanisms, that in turn support higher-quality accounting practices within financial firms.

The study also recommends improving regulatory and audit oversight in connection with both accounting approaches. That includes tightening generally accepted accounting principles to improve the quality of information provided about the impact of liquidity pricing on each valuation approach.

Policymakers also should clarify whether financial statements should include sufficient detail about fair value accounting mechanics to allow users of financial statements to reconstruct and assess the details of valuation models for themselves.

Finally, the study suggests policymakers consider a more prominent role for regulators to vet asset valuation practices at large institutions.

The study, “Fair Value Accounting, Historical Cost Accounting, and Systemic Risk: Policy Issues and Options for Strengthening Valuation and Reducing Risk,” can be found at www.rand.org. The other authors of the study are Eric Helland, Noreen Clancy and James N. Dertouzos.

The study was supported by the Goldman Sachs Global Markets Institute, with additional support from the pooled resources of the RAND Center for Corporate Ethics and Governance.

The center is committed to improving public understanding of corporate ethics, law and governance and to identifying specific ways in which businesses can operate ethically, legally and profitably. The center's work is supported by contributions from private-sector organizations and individuals with interests in research on these topics.