The role that fair value or "mark-tolmarket" accounting may have played in the recent financial crisis is the subject of an ongoing debate among practitioners, regulators, and academics (e.g., see Laux and Leuz (2009)). Proponents of fair value accounting argue that a balance sheet based on market prices leads to better insights into the current risk profiles of financial institutions. Regulators could therefore intervene in a more timely and effective manner to influence managerial decisions. Tools such as regulatory capital requirements could be used to prevent the ineffi cient choices or continuation of bad projects.
Opponents counter that market prices could only provide useful signals to outsiders if the assets and liabilities of financial institutions trade in frictionless competitive markets. However, such markets do not exist for several important claims held by institutions. Further, fair value accounting along with regulatory capital requirements that are based on market values could increase the risks faced by institutions, and induce myopic behavior by preventing the selection of efficient, long term projects. To the best of our knowledge, however, a trade off that is central to this debatem fair value accounting could mitigate in efficient choices of bad projects, but simultaneously hamper the choices of good onesm has not been theoretically formalized and its consequences examined.
We develop a theory of how agency conflicts between the shareholders and debt holders of a financial institution, accounting measurement rules, and prudential capital regulation interact to affect the institutionis project choices and capital structure. We show that, relative to the benchmark historical cost regime in which all claims are measured at their origination values, fair value accounting could mitigate the ineffi ciency arising from asset substitution or risk shifting (the choice of risky, negative NPV projects), but exacerbate under investment due to debt overhang (the avoidance of risky, positive NPV projects). The conflicting effects of fair value accounting hold even in the scenario in which the institutionis claims are traded in frictionless, competitive markets.
The in efficiencies due to under investment and asset substitution work in opposing directions in that an increase in one mitigates the other. The optimal choices of accounting measurement regime and prudential capital regulation balance the effects of under investment and asset substitution. Under fair value accounting, we show that the socially optimal solvency constraint declines with the institutionis marginal cost of investment in project quality, and with the excess cost of equity relative to debt. Our results imply that, if the respective solvency constraints in the two regimes take their socially optimal values, fair value accounting dominates historical cost accounting. If the solvency constraints are not set to their optimal values, however, historical cost accounting could dominate fair value accounting.
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Agency Conflicts, Prudential Regulation, and Marking to Market
