Did fair-value accounting contribute to the financial crisis?

10 July 2014

Since the beginning of the financial crisis, many critics have argued that fair-value accounting (e.g. IFRS) has amplified the crisis and increased financial instability. Under fair-value accounting standards, bank assets or liabilities are marked to market: that is, they are declared according to current market prices instead of book values. Thus, all gains and losses are immediately recognized in income statements. At a CFS Colloquium on 8 July, Christian Leuz, Joseph Sondheimer Professor of International Economics, Finance and Accounting at the University of Chicago Booth School of Business and CFS Research Fellow, nevertheless cited empirical evidence to make the case that fair-value accounting did not contribute to the crisis. Indeed, recent empirical analyses have not found a strong link between financial reporting standards and financial stability.

Leuz explained that financial accounting provides information for prudential regulation, market participants as well as for bank management. For example, regulators look at financial accounting figures when deciding on capital requirements for banks, and bank managers rely on this data when taking risk management decisions. However, Leuz warned, we should not overestimate the importance of accounting data. Financial reporting is usually not the only source of information available; indeed, regulators often make significant adjustments to the reported numbers for their own purposes (e.g. applying prudential filters). Similarly, investors do not solely rely on accounting information, but also consider other factors such as the overall macroeconomic situation, analyst reports or newspaper articles. Thus, Leuz concluded, these numbers have no significant effect on financial stability.

Empirical studies have shown that, before the crisis, bank assets were often overvalued in accounting reports; hence, according to Leuz, the crisis saw no excessive write-downs, but rather the write-downs that did occur served simply to mark the value of these assets closer to their fundamental value. Although there might have been downward spirals or asset fire sales in certain markets, evidence suggests that these effects were not due to the use of fair-value accounting standards. During the crisis, banks usually did not report their real exposures, and disclosures were mostly made quite late. As examples, Leuz mentioned the cases of IKB and Sachsen LB, both of which issued press releases assuring markets that they had no problems just days before being bailed out. According to Leuz, such a lack of transparency contributes to financial instability as much as the disclosure of negative information on banks.

Finally, Leuz argued that historical cost accounting (e.g. HGB) – accounting standards valuing assets at their original acquisition costs instead of at current market prices – does not make any difference for financial stability, and does not result in lower leverage compared to fair-value accounting. For example, though several German banks that got into trouble during the crisis, like IKB or HRE, were regulated based on German historical cost accounting standards rather than fair-value accounting standards, these banks were just as highly leveraged as their peers. In Leuz’s view, capital requirements can contribute more to avoiding high leverage than any specific accounting rules.