The aim of this paper is to explore the effect of financial institutions accounting rules, i.e. book or fair value, on the allocation of resources so as to identify its social costs and benefits.
During the last two decades the issue whether bank assets and liabilities should be accounted for at their historical (book) value or at market (fair) value has been the object of an intense debate among regulators. In the end, fair value accounting, supported by the Joint Working Group of Standard Setters2, seems to have the upper hand. Although these points can be disputed on the basis of asymmetric information and managerial incentives to truthfully reveal information, the prevailing view is that a sufficiently high level of penalties could restore incentives for managers to report the true market values of assets and liabilities.
The case in favour of fair value accounting has been based on the idea that fair value could increase market discipline and lead managers to take the right value maximizing decisions. Yet, it has been argued that fair value accounting increases the volatility of banks profits, and this will hurt the business of banking, which is based on the long term relationship of a bank with its clients (Chisnall, 2000). Additionally, it has been argued that fair value accounting lacks accuracy as it relies on subjective proxies for the market value of nontradeable financial products (as loans). On the other hand, value accounting may help preventing systemic crises, as information on banks financial distress is obtained earlier3.
This paper takes a completely different view of the book vs. fair value accounting debate.
Our objective is not to counter this argument but to point out that there is at least another important dimension at work, the degree of intertemporal smoothing, and that it may support the use of book value accounting. From that perspective, the main achievement of our paper is to show the dark side of the comparison and to point out that the use of fair value accounting does not dominate book value accounting in a straightforward and robust way. Moreover, if we allow for fair value disclosure, the whole argument in favour of fair value accounting seems to vanish4. Indeed, the market discipline argument is based on disclosure of the fair value of assets and liabilities, not on its effective use in accounting with its fiscal and legal implications.
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