Fair Value Accounting, Historical Cost Accounting, and Systemic Risk

Policy Issues and Options for Strengthening Valuation and Reducing Risk

by Michael D. Greenberg, Eric Helland, Noreen Clancy, James N. Dertouzos

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Research Questions

  1. What is the relationship between accounting standards (fair value accounting and historical cost accounting) and "systemic risk" (i.e., the contagion of financial risk across institutions, with the potential to destabilize the entire financial system)?
  2. What kinds of regulatory, governance, and accounting standards options might policymakers consider to respond to related concerns about systemic risk?

Fair value accounting (FVA) refers to the practice of updating the valuation of assets or securities on a regular basis, ideally by reference to current prices for similar assets or securities established in the context of a liquid market; historical cost accounting (HCA) instead records the value of an asset as the price at which it was originally purchased. In the wake of the 2008 financial crisis, conflicting arguments have been made about the contributions of valuation approaches in triggering the crisis. This report investigates and clarifies the relationship between these two accounting approaches and risks to the financial system. The authors examine the risk implications of FVA and HCA in the various situations in which each is used; assess the role that these accounting approaches have played historically in financial crises, including the 2008 financial crisis, the savings and loan crisis of the 1980s, and the less developed country debt crisis of the 1970s; and explore insights about systemic risk that can be gleaned from better understanding the accounting approaches.

The authors find that FVA was probably not a primary driver of the 2008 crisis. Moreover, they suggest that neither FVA nor HCA is objectively "better" than the other. Instead, both accounting approaches can provide useful information for different contexts when applied rigorously, but when they are implemented poorly or when regulatory oversight is weak, both FVA and HCA can produce misleading information that can increase systemic risk across the financial sector. The authors conclude with a series of recommendations for how FVA and HCA, and the financial information that both methods generate, can be improved to better protect against systemic risk to the banking sector in the future.

Key Findings

The Key Question Is Not Whether Fair Value Accounting (FVA) or Historical Cost Accounting (HCA) Is "Better" but Instead How to Ensure That Each Is Implemented Properly

  • Both FVA and HCA can be associated with systemic risk to the financial system under some circumstances.
  • Available empirical evidence does not provide strong support for the claim that FVA was a primary driver of the 2008 financial crisis.
  • When implemented poorly, both FVA and HCA can produce misleading information and lead to risk accumulation problems and the potential for market distortion.
  • Improving the quality of both FVA and HCA information in financial statements should be a priority consideration for policymakers.

Recommendations

  • Consider new steps to strengthen institutional governance and control mechanisms that in turn support higher-quality fair value accounting (FVA) and historical cost accounting (HCA) practices within financial firms.
  • Strengthen FVA and HCA approaches to valuation by improving regulatory and audit oversight in connection with both approaches.
  • Tighten generally accepted accounting principals (GAAP) standards in connection with both FVA and HCA, to improve the quality of information provided about the impact of liquidity pricing on each valuation approach.
  • Clarify whether financial statements truly are required to disclose sufficient detail about FVA mechanics to allow users of financial statements to reconstruct and assess the details of valuation models for themselves.
  • Consider developing or adding metrics of valuation robustness to augment standard financial disclosures under GAAP.
  • Consider adding disclosure requirements to address situations in which market power and other forms of price endogeneity are likely to influence FVA observed market values.
  • When strengthening regulatory capital requirements, consider the potential for perverse asset valuation and institutional governance effects.
  • Evaluate whether asset risk-weighting in bank capital requirements has the potential to contribute to perverse risk effects and contagion, in connection with FVA.
  • Consider a more prominent role for prudential regulators in vetting asset valuation practice at large institutions.

Table of Contents

  • Chapter One

    Introduction

  • Chapter Two

    Background: The Debate over FVA and HCA

  • Chapter Three

    Systemic Risk and Accounting Approaches

  • Chapter Four

    Accounting Standards and Prudential Regulation

  • Chapter Five

    Lessons from Historical Episodes Involving Accounting Standards, Systemic Risk, and Financial Crisis

  • Chapter Six

    Implementation and Risk: The Challenges to Doing FVA and HCA Well

  • Chapter Seven

    Conclusion and Policy Options

  • Appendix

    An Overview of HCA and FVA

The research described in this report was supported in part by the Goldman Sachs Global Markets Institute, with additional support from the generosity of RAND's donors and by the fees earned on client-funded research, and was conducted in the RAND Center for Corporate Ethics and Governance, a part of the RAND Institute for Civil Justice.

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