Marking-to-Market: Panacea or Pandora's Box?

Finance

IFA Working Paper

Plantin G;Sapra H;Shin H S

2007

Financial institutions have been at theforefront of the debate on the controversial shift in international standards from historical cost accounting to mark-to-market accounting. We show that the trade-offs at stake in this debate are far from one-sided. While the historical cost regime leads to some inefficiences, marking to market may lead to other types of inefficiences by injecting artifical risk 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 find 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 result therefore shed light on why banks and insurance companies have been the most vocal opponents of the shift to marking to market.

Institute of Finance and Accounting

FIN 469

IFA Working Paper

No