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					    Fair Value Accounting and
       Financial Stability
             Haresh Sapra
        The University of Chicago

Prepared for the 3rd Annual Nykredit Symposium
            Copenhagen, Denmark
               October 26, 2009
       Case for Fair Value Accounting
• Market price reflects current terms of trade between willing
  parties


• Market price gives better indication of current risk profile
   – Market discipline
   – Informs investors, better allocation of resources


• Good corporate governance and fair value accounting are
  seen as two sides of the same coin.



                                                                 2
      Two Insights from my research
1. Theory of the Second-Best:
   When there is more than one imperfection in an
    economy, removing one of them need not improve
    welfare.
   In the presence of other imperfections (illiquidity,
    agency problems, etc.) fair value accounting need not
    be welfare improving.
2. Information has strategic consequences:
   Firm is not a black box that operates independently of
    the measurement environment.
   Measuring a firm's cash flows changes the very cash
    flows that one is seeking to measure.

                                                             3
       Transparency may potentially be
       achieved in a variety of ways…..

1. Fair Value Accounting: use of market prices or
   market inputs to value assets and liabilities.

2. Higher Frequency of Mandatory Disclosures.

3. Higher Precision of Mandatory Disclosures.




                                                    4
    Increasing Transparency via the Frequency of
           Mandatory Financial Reporting
• Managers chooses between a short-term and a long-term project
  to maximize the path of expected stock prices, i.e.,

                Max  E0 ( P1 )  (1   ) E0 ( P2 )

• Short-term project differs from the long term project as follows:

       Short term project generates higher stochastic cash flows
        in the early periods but lower stochastic cash flows in the
        future periods.

       But, long term project maximizes social welfare.


                                                                      5
   Increasing Transparency via the Frequency of
          Mandatory Financial Reporting
• Now consider an environment with the following two
  imperfections:
   – Insiders know more about the profitability about the underlying projects
     but such information cannot be credibly disclosed to outsiders.
   – While outsiders can observe the cash flows from the projects, they
     cannot discern between the short-term versus the long-term project.


• In a first-best world, shareholder myopia, by itself, does not
  induce the manager to choose the short-term project! Why?
   – Because prices are forward looking, manager chooses the long term
     project.


                                                                                6
Increasing Transparency via the Frequency of
       Mandatory Financial Reporting

• Given this second-best environment, should regulators
  increase the frequency of mandatory reporting?

   – While more frequent disclosure makes prices more efficient,
     it also induces the manager to choose the short-term project,
     which reduces economic efficiency.
   – Less information could provide better incentives by
     destroying information.
   – Information has strategic consequences and measuring the
     cash flows of a firm changes the very cash flows that are
     being measured!

                                                                     7
 Increasing Transparency via a higher precision of
               accounting numbers
• Consider a firm that chooses an investment level k to
  maximize:
                          k  v( k ,  )  c( k )

• In a full information world, k * ( ) satisfies:
              c ' (k )                                   vk (k , )
     marginal cost of investment       marginal short term return + marginal long term return



• Given vk (k ,  )  0 , the full information investment
  level k * ( ) is increasing in .
                                                                                                8
    Increasing transparency via a higher Precision of
                   accounting numbers
• Two potential sources of information asymmetry between the
  capital market and the firm’s insiders:

    1.   Firm-level profitability      is private information.

    2.   Firm’s investment level    k    can only be disclosed with noise via an
         accounting report:
         e.g., y  k   where            f () with mean 0 and variance  2

•   Given this second-best environment, should the firm's
    investment level k be made as transparent as possible to
    outsiders? In other words, should  2  0.

                                                                                   9
     Increasing transparency via a higher precision
                  of accounting numbers
•   Suppose  is publicly observable, but the firm’s investment
    level k is imprecisely measured via the accounting report y.

    – Given  , outsiders rationally conjecture that the firm’s investment level
      is given by some investment schedule, kc ( ) .

    – The market price of the firm is then given by:

                         ( y, )  E (v(kc ( ), ) | y, )
       which does not depend on y, the firm’s accounting report!

    – Let the equilibrium pricing rule be described by some schedule   c ( )


                                                                                   10
   Increasing transparency via a higher precision
               of accounting numbers
• Firm therefore chooses k to maximize:
                         k  c(k )  c ( )
  so that the firm’s equilibrium investment schedule is given by:
                           c ' (kM ( ))

• The firm therefore invests myopically in order to maximize only
  its short term return but not its long term return!

• The firm is trapped in a bad equilibrium.



                                                                    11
  Increasing transparency via a higher precision of
                accounting numbers
• Suppose the firm’s investment level k is perfectly
  observable but its profitability parameter  is private
  information to the firm’s insiders.

   – The capital market knows that the firm invests k in light of its
     private information  .
   – In evaluating the cash flow consequences of an investment k, the
     capital market makes inferences about the value of  from k.
   – The firm’s investment now potentially acquires an informational
     role apart from its cash flow role!
   – If the capital market form the rational beliefs that a larger k implies
     a larger  , then the firm is rationally induced to overinvest in k.


                                                                               12
  Increasing transparency via a higher precision of
                accounting numbers
• Removing just one of these two sources of information
  asymmetry without addressing the other source would
  affect the market's expectations of future cash flows in
  such a way that the firm invests sub-optimally.

   – When the firm’s profitability parameter cannot be
     credibly disclosed, some imprecision in the
     measurement of investment is socially optimal!




                                                             13
          Financial Institutions
• Illiquid assets such as long term loans, corporate
  bonds, and structured derivative products:
  – Do not trade in deep and liquid markets

  – Trade in OTC markets where prices are determined
    via bilateral bargaining and matching

  – Fair value computed using stochastic discount rates
    implied by recent transactions of comparable assets


                                                          14
        What about volatility?
• If the fundamentals are volatile, then so be
  it .

• Market price is volatile…

• …but it simply reflects the volatility of the
  fundamentals


                                                  15
        “Artificial” Volatility
• Dual role of market price
  – Reflection of fundamentals
  – Influences actions

          Actions                Prices



• Reliance on market prices distorts market
  prices.
  – Endogenous Risk
                                              16
                   Liquidity Pricing
Price, P                               ~
                                  , E(R)
                       P = Min
                                 L


     ~
   E(R)
           Liquidity Pricing




     O                                                    (Liquidity)
                    < *        *          > *

                                                                 17
            Liquidity Shortage        Excess Liquidity
Plantin, Sapra, and Shin (2008)

In a world of market imperfections such
illiquid and incomplete markets, what are
the real effects of a historical cost
measurement regime versus a fair value
accounting measurement regime?




                                            18
       Historical Cost vs. MTM
• Historical Cost Accounting: decisions not
  sensitive enough to market prices.
  – e.g., Savings and Loans crises

• Fair Value Accounting: decisions too
  sensitive to market prices.
  – Excess volatility in financial markets
  – Fair Value Accounting exacerbates endogenous
    risk
                                                   19
                        Model
• At date 0, each FI owns an asset acquired at v0

• At date 0, manager chooses to:
  – Hold asset
  – Sell asset (buy default protection)

• Aims to maximize date 1 expected value


• But asset may be long-lived…
                                                    20
               Duration of Asset


Sell or hold      probability 1– d   probability d
                  cash flow v        cash flow v



   Date 0            Date 1            Date 2




                                                     21
       Three Notions of Value
• Fundamental value v:
  – Even though FI has good information on v
  – Cannot be used by outsiders to value asset


• Historical Cost: original cost, v0

• Fair Value Accounting: market price, p


                                                 22
              Market Price
• Market price
                 p  v  s
• Lower ability to extract value   (  1)

• Limited absorption capacity      (  0)


                                             23
      Date 1 Accounting Values
             (as seen from decision date)



                   Hold                     Sell

historical
             1  d v  dv0
   cost
                                               
                                      v  s
 mark to
             1  d v  dp                        2
 market


                                                       24
Expected Payoffs: Holding vs. Selling
• Under a historical cost regime, banks sell:

                                  
          d    1 v  dv0        s
                                  2

• Under a mark-to-market regime, banks sell:
                                 1
        1  d 1    v   d    s
                                 2
                                                25
       Fundamental Trade-off
• Historical cost Accounting:
  – Sell when fundamentals are relatively high
  – Sales are counter-cyclical
  – Inefficient when fundamentals are good


• Marking to market:
  – Sell when fundamentals are relatively low
  – Sales are pro-cyclical
  – Inefficient when fundamentals are bad.

                                                 26
        Implications of the Model….
1. For sufficiently short-lived assets, fair value accounting induces
   lower inefficiencies than historical cost accounting. The
   converse is true for sufficiently long-lived assets.

2. For sufficiently liquid assets, fair value accounting induces lower
   inefficiencies than historical cost accounting. The converse is
   true for sufficiently illiquid assets.

3. For sufficiently junior assets, fair value accounting induces
   lower inefficiencies than historical cost accounting. The
   converse is true for sufficiently senior assets.


                                                                        27
 Plantin, Sapra, and Shin (2009)
Consider a world where balance sheets are
continuously marked to market. Price
changes would show up immediately as
changes in net worth.

– What are the reactions to changes in net worth?
– What are the aggregate consequences to such
  reactions?



                                                    28
Fair Value Accounting as an Amplification
              Mechanism




                                            29
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Fair Value Accounting as an Amplifier




                                        33
            Concluding Remarks
• Accounting is relevant because we live in a world with market
  imperfections…

• Accounting standards thus have far-reaching consequences
  for the working of financial markets, and for the amplification
  of financial cycles.

• To the extent that accounting standards have such far-reaching
  impact, the constituency that is affected by the accounting
  standard setters may be much broader than the constituency
  that the accounting standard setters have in mind when setting
  standards.

                                                                    34

				
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