Fair Value Accounting and Financial Stability

1. Fair Value Accounting and Financial Stability Haresh SapraThe University of Chicago Prepared for the 3rd Annual Nykredit Symposium Copenhagen, Denmark October 26, 2009

2. 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.

3. Two Insights from my research • 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. • 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.

4. Transparency may potentially be achieved in a variety of ways….. • Fair Value Accounting: use of market prices or market inputs to value assets and liabilities. • Higher Frequency of Mandatory Disclosures. • Higher Precision of Mandatory Disclosures.

5. 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., • 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.

6. 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.

7. 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!

8. Increasing Transparency via a higher precision of accounting numbers • Consider a firm that chooses an investment level k to maximize: • In a full information world, satisfies: • Given , the full information investment level is increasing in .

9. Increasing transparency via a higher Precision of accounting numbers • Two potential sources of information asymmetry between the capital market and the firm’s insiders: • Firm-level profitability is private information. 2. Firm’s investment level can only be disclosed with noise via an accounting report: • Given this second-best environment, should the firm's investment level k be made as transparent as possible to outsiders? In other words, should

10. Increasing transparency via a higher precision of accounting numbers • Suppose is publicly observable, but the firm’s investment level is imprecisely measured via the accounting report y. • Given , outsiders rationally conjecture that the firm’s investment level is given by some investment schedule, . • The market price of the firm is then given by: which does not depend on y, the firm’s accounting report! • Let the equilibrium pricing rule be described by some schedule

11. Increasing transparency via a higher precision of accounting numbers • Firm therefore chooses k to maximize: so that the firm’s equilibrium investment schedule is given by: • 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.

12. 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 . • 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 .

13. 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!

14. 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

15. 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

16. “Artificial” Volatility • Dual role of market price • Reflection of fundamentals • Influences actions • Reliance on market prices distorts market prices. • Endogenous Risk Actions Prices

17. ~ P = Min , E(R) L Liquidity Pricing Liquidity Pricing Price, P ~ E(R)  O (Liquidity) *  < *  > * Liquidity Shortage Excess Liquidity

18. 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

19. 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

20. 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…

21. Duration of Asset probability 1– d cash flow v probability d cash flow v Sell or hold Date 0 Date 1 Date 2

22. 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

23. Market Price • Market price • Lower ability to extract value • Limited absorption capacity

24. Date 1 Accounting Values(as seen from decision date) historical cost mark to market

25. Expected Payoffs: Holding vs. Selling • Under a historical cost regime, banks sell: • Under a mark-to-market regime, banks sell:

26. Fundamental Trade-off • Historical cost Accounting: • Sell when fundamentalsare relatively high • Sales are counter-cyclical • Inefficient when fundamentals are good • Marking to market: • Sell when fundamentalsare relatively low • Sales are pro-cyclical • Inefficient when fundamentals are bad.

27. Implications of the Model…. • 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.

28. 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?

29. Fair Value Accounting as an Amplification Mechanism

33. Fair Value Accounting as an Amplifier

34. 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.