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I. INTRODUCTION
The current financial crisis has reinvigorated a debate on the effectiveness of the existing
accounting and regulatory frameworks for banks. Questions abound, ranging from adequate
capitalization levels of banks to the boundaries of financial regulation (see Financial Stability
Forum, 2008). Part of the debate on financial reform centers around required information on
banks for effective market discipline and supervisory action. This includes not only thinking on
the required level of detail on disclosure of bank assets and liabilities but also on their valuation
techniques and the appropriateness of current accounting rules more generally (see Laux and
Leuz, 2009, for a survey).
Part of this debate centers around the pros and cons of fair value accounting, where fair
value is meant to indicate the price at which an asset could be bought or sold in a current
transaction between willing parties, other than in a liquidation. Accounting standards stipulate
that as a guiding principle, the quoted market price in an active market should be used as the
basis for the measurement of the fair value of an asset. The problem is that such a price is not
always available, for example, in illiquid markets. In such cases, fair values need to be estimated
based on available information. A related concern is the potential procyclical nature of fair value
accounting, which could magnify fluctuations in bank lending and economic activity (see IMF,
2009, and Heaton et al., 2009). A broader concern is that the current “mixed attribute” model of
accounting, in which some financial instruments are measured based on historical cost and some
at fair value, together with discretion over how financial instruments are measured, gives rise to
accounting arbitrage.2
Despite difficulties of determining fair values in illiquid markets, advocates of fair value
accounting maintain that fair value is the most relevant measure for financial instruments.3 They
argue that financial assets, even complex instruments, tend to trade continuously in markets and
it should therefore be possible to use information embedded in market prices to compute fair
values of financial assets.
Faced with massive write-downs and expected losses, banks in contrast have used the
momentum to lobby against the use of fair value accounting. They claim that most of their assets
are currently not impaired, that they intend to hold them to maturity anyway, and that market
prices reflect distressed sales into an illiquid market. Potential buyers of such assets, however,
are unlikely to value them at origination value but at prices well below book value. Banks may
ignore such signals to avoid recognizing a loss, claiming that unusual market conditions, not an
actual decline in value, cause low market pricing.

2

As emphasized by Jackson M. Day, Deputy Chief Accountant, U.S. Securities and Exchange Commission, in his
year 2000 remarks “Fair Value Accounting–Let's Work Together and Get It Done!” at the 28th Annual National
Conference on Current SEC Developments.

3

See, for example, Kaplan, Robert, Robert Merton and Scott Richard, 2009, “Disclose the fair value of complex
securities”, Financial Times, August 17, 2009.