Fair value accounting for financial instruments: some implications for bank regulation

BIS Working Papers No 209
August 2006

On 11-12 November 2005, the BIS held a workshop on Accounting, risk management and prudential regulation, which brought together a multi-disciplinary group of around 35 external participants including senior accounting practitioners, standard setters, finance academics, supervisors and central bank officials. The workshop programme is attached. This paper was presented at the workshop.

Abstract:

I identify issues that bank regulators need to consider if fair value accounting is used for determining bank regulatory capital and when making regulatory decisions. In financial reporting, US and international accounting standard setters have issued several disclosure and measurement and recognition standards for financial instruments and all indications are that both standard setters will mandate recognition of all financial instruments at fair value. To help identify important issues for bank regulators, I briefly review capital market studies that examine the usefulness of fair value accounting to investors, and discuss marking-to-market implementation issues of determining financial instruments' fair values. In doing so, I identify several key issues. First, regulators need to consider how to let managers reveal private information in their fair value estimates while minimising strategic manipulation of model inputs to manage income and regulatory capital. Second, regulators need to consider how best to minimise measurement error in fair values to maximise their usefulness to investors and creditors when making investment decisions, and to ensure bank managers have incentives to select investments that maximise economic efficiency of the banking system. Third, cross-country institutional differences are likely to play an important role in determining the effectiveness of using mark-to-market accounting for financial reporting and bank regulation.

JEL classification: E58, G15, M41.

Keywords: Fair values, financial instruments, information asymmetry