Procyclicality

The most damning charge against fair value accounting (FVA) is that it promotes volatility in the financial markets. The link in the title is to chapter 3 of the IMF's October Financial Stability Report. I had high hopes of this chapter but the analysis is woolly at times. The authors spend some time showing that FVA promotes volatility in financial reporting. That much is obvious. They provide some useful data on what proportions of banks fair-valued items are based on market values (level 1 - 25%), what are influenced by market values (level 2 - 69%) and what are 'marked to model' (level 3 - 6%) They then go on to simulate the impact of fair value on banks balance sheets through an economic cycle. They find that fair value is indeed procyclical, except in the case of the property cycle where falls in property values have the effect of increasing American investment banks' equity due to the fall in the fair value of their own debt. (Very counter-intuitive - fair value shows the banks getting better off because their creditworthiness has fallen.)

The authors don't conclude that fair value should be abandoned but rather than banks need to be regulated in a way that builds up reserves in good times to prepare for worse times to come.

The analysis is very partial because it fails to model the moral hazard inherent in fair value profit measurement. While it acknowledges that fair value can lead to instability in the system the authors take as given that financial reporting standards are directed at individual organisations and can ignore systematic effects. My own view is that financial reporting is all about increasing the economic welfare of society and refining the value of securities in second-hand markets is secondary to stability of the system and providing an environment where economic actors can contract efficiently with each other.