Marketing Pandora.pdf - Marking-to-Market Panacea or...

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Marking-to-Market: Panacea or Pandora’s Box? Guillaume Plantin Tepper School of Business Carnegie Mellon University 5000 Forbes Avenue Pittsburgh, PA 15213, U.S.A. Haresh Sapra University of Chicago GSB 5807 South Woodlawn Avenue Chicago, IL 60637, U.S.A. Hyun Song Shin London School of Economics, Houghton Street, London WC2A 2AE, U. K. September 2005 Abstract Financial institutions have been at the forefront of the debate on the controversial shift in international standards from historical cost accounting to mark-to-market accounting. We show that the tradeo ff s at stake in this debate are far from one- sided. While the excessive conservatism in the historical cost regime leads to some ine ciencies, marking to market may lead to other types of ine ciencies by injecting arti fi cial volatility that degrades the information value of prices, and induces sub- optimal real decisions. We construct a framework that can weigh the pros and cons. We fi nd that the damage done by marking to market is greatest when claims are (i) long-lived, (ii) illiquid, and (iii) senior. These are precisely the attributes of the key balance sheet items of banks and insurance companies. Our results therefore shed light on why banks and insurance companies have been the most vocal opponents of the shift to marking to market. We thank participants in various seminars, and, in particular, Ron Dye, Xavier Freixas, Charles Good- hart, Rafael Repullo, Jean-Charles Rochet for their comments. Catherine Xu provided excellent research assistance. Sapra acknowledges Financial Support from the FMC Faculty Research Fund at the Graduate School of Business, the University of Chicago. 1
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1 Introduction Accounting is often seen as a veil - as a mere detail of measurement - leaving the economic fundamentals una ff ected. However, the intensity of the public debate surrounding account- ing reforms in recent years suggests that there may be more at stake than esoteric debates on measurement. The immediate cause of the recent debate has been the initiative of the International Accounting Standards Board (IASB) and the U. S. Financial Accounting Standards Board (FASB) toward convergence of accounting standards to a global one based on the information that is provided by prevailing market prices - sometimes known as a “fair value” or “mark- to-market” reporting system. This is in contrast to measurement systems based on historical cost which require fi rms to record their assets and liabilities at their original prices with no adjustments for subsequent changes in the market values of those items. 1 Proponents of marking to market argue that the market value of an asset is more relevant than historical cost because it re fl ects the amount at which that asset could be bought or sold in a current transaction between willing parties. Similarly, the market value of a liability is more relevant than historical cost because it re fl ects the amount at which that liability could be incurred or settled in a current transaction between willing parties. A measurement
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