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Is mark-to-market accounting destabilizing? Analysis and implications for policy

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  • Heaton, John C.
  • Lucas, Deborah
  • McDonald, Robert L.

Abstract

Fundamental economic principles provide a rationale for requiring financial institutions to use mark-to-market, or fair value, accounting for financial reporting. The recent turmoil in financial markets, however, has raised questions about whether fair value accounting is exacerbating the problems. In this paper, we review the history and practice of fair value accounting, and summarize the literature on the channels through which it can adversely affect the real economy. We propose a new model to study the interaction of accounting rules with regulatory capital requirements, and show that even when market prices always reflect fundamental values, the interaction of fair value accounting rules and a simple capital requirement can create inefficiencies that are absent when capital is measured by adjusted book value. These distortions can be avoided, however, by redefining capital requirements to be procyclical rather than by abandoning fair value accounting and the other benefits that it provides.

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Bibliographic Info

Article provided by Elsevier in its journal Journal of Monetary Economics.

Volume (Year): 57 (2010)
Issue (Month): 1 (January)
Pages: 64-75

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Handle: RePEc:eee:moneco:v:57:y:2010:i:1:p:64-75

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Web page: http://www.elsevier.com/locate/inca/505566

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Keywords: Mark-to-market accounting Price of risk;

References

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  1. Anna Pavlova & Roberto Rigobon, 2008. "The Role of Portfolio Constraints in the International Propagation of Shocks," Review of Economic Studies, Oxford University Press, vol. 75(4), pages 1215-1256.
  2. Xiong, Wei, 2001. "Convergence trading with wealth effects: an amplification mechanism in financial markets," Journal of Financial Economics, Elsevier, vol. 62(2), pages 247-292, November.
  3. Allen, Franklin & Carletti, Elena, 2006. "Mark-to-market accounting and liquidity pricing," CFS Working Paper Series 2006/17, Center for Financial Studies (CFS).
  4. John Moore & Nobuhiro Kiyotaki, . "Credit Cycles," Discussion Papers 1995-5, Edinburgh School of Economics, University of Edinburgh.
  5. Guillaume Plantin & Haresh Sapra & Hyun Shin, . "Marking to Market: Panacea or Pandora’s Box ?," GSIA Working Papers 2005-E4, Carnegie Mellon University, Tepper School of Business.
  6. Wayne Landsman, 2006. "Fair value accounting for financial instruments: some implications for bank regulation," BIS Working Papers 209, Bank for International Settlements.
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Citations

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Cited by:
  1. Allen, Franklin & Carletti, Elena, 2013. "New theories to underpin financial reform," Journal of Financial Stability, Elsevier, vol. 9(2), pages 242-249.
  2. Huizinga, Harry & Laeven, Luc, 2009. "Accounting discretion of banks during a financial crisis," CEPR Discussion Papers 7381, C.E.P.R. Discussion Papers.
  3. Raimond Maurer & Olivia S. Mitchell & Ralph Rogalla & Ivonne Siegelin, 2014. "Accounting and Actuarial Smoothing of Retirement Payouts in Participating Life Annuities," NBER Working Papers 20124, National Bureau of Economic Research, Inc.
  4. Philip Bond & Yaron Leitner, 2010. "Market run-ups, market freezes, and leverage," Working Papers 10-36, Federal Reserve Bank of Philadelphia.
  5. Philip Bond & Yaron Leitner, 2009. "Why do markets freeze?," Working Papers 09-24, Federal Reserve Bank of Philadelphia.
  6. Huang, Xin & Zhou, Hao & Zhu, Haibin, 2012. "Assessing the systemic risk of a heterogeneous portfolio of banks during the recent financial crisis," Journal of Financial Stability, Elsevier, vol. 8(3), pages 193-205.
  7. Andrew Ellul & Chotibhak Jotikasthira & Christian T. Lundblad & Yihui Wang, 2012. "Is Historical Cost Accounting a Panacea? Market Stress, Incentive Distortions, and Gains Trading," FMG Discussion Papers dp701, Financial Markets Group.
  8. Leila Gharbi & Khamoussi Halioui, 2011. "La juste valeur des instruments financiers : Un nouveau canal de contagion ?," Post-Print hal-00650435, HAL.
  9. John H. Cochrane, 2011. "Discount Rates," NBER Working Papers 16972, National Bureau of Economic Research, Inc.
  10. Mary E. Barth & Javier Gomez-Biscarri & Ron Kasznik & Germán López-Espinosa, 2012. "Fair Value Accounting, Earnings Management and the use of Available-for-Sale Instruments by Bank Managers," Faculty Working Papers 05/12, School of Economics and Business Administration, University of Navarra.

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