The Financial Accounting Standards Board has proposed revised accounting rules that would require all financial assets to be held at market value.  

Right now, most banks account for loans at historical cost, which does not require loss provisions to be booked until delinquencies arise in the portfolio, which is typically a slow process.  In contrast, market values for loans can plummet rapidly, well before delinquencies emerge, when investors pick up on weakening economic trends or deterioration in the loan’s collateral, which helps them anticipate future delinquencies.

Many people (especially in the banking industry) are alarmed that market value accounting will increase the volatility of bank balance sheets.  This is true, in the sense that banks will be forced to mark down loan values much more quickly if a crisis hits, whereas under historical accounting, the markdown isn’t booked until the delinquencies appear.  Markdowns lead to pressure on bank capital, even failure, which could happen faster under market accounting.

In my view, market accounting would be a positive, because it would force banks to face up to the riskiness of their assets, which can lose value quickly in a crisis.  The logical response would be for banks to hold more capital, which would make the financial system somewhat more robust.

Additionally, market value accounting would force banks to recapitalize more quickly, which could help speed us through the crisis and on to recovery.

Some people are suspicious of market value accounting because they think markets may become illiquid or even irrational.

The question is, who would you rather believe, the market, or a bank?

One nit with marked value accounting:  while banks should mark their assets to market, they should not mark down their own debt.  In a crisis, a bank’s assets will lose value, as investors start to discount the possibility that borrowers might default.  For example, a loan might trade down from par (100% of its outstanding balance) to say 90%, as investors start to discount something like a 20% probability of default and a 50% loss on the loan upon default (20%X50% = 10% discount).  The bank’s books should reflect this mark-down in the loan’s value, which reflects the loan’s heightened risk.

If the bank has enough of these risky loans, the bank’s own debt may start to trade off, as investors begin to weigh the possibility that the bank itself might default.

Suppose the bank’s debt trades off from par to 90%.  Under market value accounting, the bank would be able to recognize a gain (an increase in its equity) equal to the 10% market discount in its debt.  You might think it only fair for the bank to carry its liabilities at market, since that is how it accounts for its assets.  But there is a flaw in the logic.  If the bank marks its own debt down to 90%, then its financial statements are now presenting a muddled picture:  as if they mixed an 80% weighting on the institution as a going concern with a 20% weighting on it as a failure.  

This muddled presentation is confusing, because the financial statements are presented as those of a going concern, not those of a mix of states.  Worse, the muddled presentation exaggerates the equity of the entity as a going concern (it will need to pay off all of its debt, not just 80% of it).  Finally, the muddled presentation does not present accurate information about the financial statements of the entity as a failure because the bankruptcy (or receivership) process is complicated and typically includes many other adjustments to the books besides a haircut on the debt.