Both Fair Value and Historical Cost Accounting Contribute to Systemic Risk in the Financial Sector
Oct 9, 2013
In the wake of the 2008 financial crisis, conflicting arguments have been made about fair value accounting (FVA) versus historical cost accounting (HCA) and the role that each played in the crisis. This report examines the relationship between both types of accounting practices and systemic risk in the financial sector, providing recommendations on how FVA and HCA can both be improved.
Policy Issues and Options for Strengthening Valuation and Reducing Risk
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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.
Background: The Debate over FVA and HCA
Systemic Risk and Accounting Approaches
Accounting Standards and Prudential Regulation
Lessons from Historical Episodes Involving Accounting Standards, Systemic Risk, and Financial Crisis
Implementation and Risk: The Challenges to Doing FVA and HCA Well
Conclusion and Policy Options
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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