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The Key Question Is Not Whether Fair Value Accounting (FVA) or Historical Cost Accounting (HCA) Is "Better" but Instead How to Ensure That Each Is Implemented Properly

• Both FVA and HCA can be associated with systemic risk to the financial system under some circumstances.
• Available empirical evidence does not provide strong support for the claim that FVA was a primary driver of the 2008 financial crisis.
• When implemented poorly, both FVA and HCA can produce misleading information and lead to risk accumulation problems and the potential for market distortion.
• Improving the quality of both FVA and HCA information in financial statements should be a priority consideration for policymakers.

Fair value accounting (FVA) refers to the practice of updating the valuation of assets or securities on a regular basis, ideally by reference to current prices for similar assets or securities established in the context of a liquid market; historical cost accounting (HCA) instead records the value of an asset as the price at which it was originally purchased. In the wake of the 2008 financial crisis, conflicting arguments have been made about the contributions of valuation approaches in triggering the crisis. This report investigates and clarifies the relationship between these two accounting approaches and risks to the financial system. The authors examine the risk implications of FVA and HCA in the various situations in which each is used; assess the role that these accounting approaches have played historically in financial crises, including the 2008 financial crisis, the savings and loan crisis of the 1980s, and the less developed country debt crisis of the 1970s; and explore insights about systemic risk that can be gleaned from better understanding the accounting approaches.

The authors find that FVA was probably not a primary driver of the 2008 crisis. Moreover, they suggest that neither FVA nor HCA is objectively "better" than the other. Instead, both accounting approaches can provide useful information for different contexts when applied rigorously, but when they are implemented poorly or when regulatory oversight is weak, both FVA and HCA can produce misleading information that can increase systemic risk across the financial sector. The authors conclude with a series of recommendations for how FVA and HCA, and the financial information that both methods generate, can be improved to better protect against systemic risk to the banking sector in the future.

• Chapter One

  Introduction

• Chapter Two

  Background: The Debate over FVA and HCA

• Chapter Three

  Systemic Risk and Accounting Approaches

• Chapter Four

  Accounting Standards and Prudential Regulation

• Chapter Five

  Lessons from Historical Episodes Involving Accounting Standards, Systemic Risk, and Financial Crisis

• Chapter Six

  Implementation and Risk: The Challenges to Doing FVA and HCA Well

• Chapter Seven

  Conclusion and Policy Options

• Appendix

  An Overview of HCA and FVA