BANKING ACCOUNTING AND FINANCIAL PLATFORM

Abstract

The accounting scandals of recent years have further  strengthened the hands of the proponents of fair value accounting.  Market prices give timely signals that can aid decision making. However, in the presence of distorted incentives and illiquid markets, there are other less benign effects that inject artificial volatility to prices that distorts real decisions. In a world of marking-to-market, asset price changes show up immediately on the balance sheets of financial intermediaries and elicit responses from them. Banks and other intermediaries have always responded to changes in economic environment, but marking-to-market sharpens and synchronises their responses, adding impetus to the feedback effects in financial markets. A pre-condition for the application of fair value accounting is that market values are available for the assets or liabilities in question. However, for many important classes of assets or liabilities, the prices at which transactions take place do not match up well to the ideal of the hypothetical frictionless competitive market .For junior assets trading in liquid markets (such as traded stocks), marking-to-market is superior to historical cost in terms of the trade-offs. But for senior, long-lived and illiquid assets and liabilities (such as bank loans and insurance liabilities), the harm caused by distortions can outweigh the benefits. We review the competing effects and weigh the arguments.