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resources. When the market is denied critical information, its participants will infer what they
can from existing information, in which case rumors, fears, and wishful thinking will play a
much bigger role in how the market determines prices and quantities. Therefore, from a
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House Oversight Committee Testimony November 13, 2008
systemic risk perspective, as well as a social welfare perspective, it is difficult to justify any
regulatory change that interferes with or otherwise reduces transparency.
One example of such a change is the recent proposal to suspend Fair-Value Accounting (FASB
Statement No. 157). Fair-value or mark-to-market accounting requires firms to value their assets
and liabilities at fair market prices, not on a historical-cost basis, and this practice has been
blamed for the current financial crisis because it has forced many firms to write down their
assets, thereby triggering defaults and insolvencies. At first blush, this proposal seems ill-
conceived because it calls for less transparency. After all, in the current credit crisis, banks are
refusing to lend to each other because they have no idea what the other banks assets are worth,
and suspending fair-value accounting will not improve this state of affairs. Imagine a doctor
advising the parents of a feverish child to discontinue hourly temperature readings because the
frequent readings only serve to alarm them. Instead, the doctor suggests that the parents either
wait until the child is feeling better before taking the next reading, or that they construct an
estimate of the child s temperature based on readings taken last week when the child was feeling
better.
Nevertheless, the proposal is worth more serious consideration because it involves several subtle
issues surrounding the economic nature of markets, prices, and the importance of transparency.
There is no doubt that a suspension of fair-value accounting will reduce current pressures on a
number of potential insolvent financial institutions. However, this reduction in current pressures
comes at a cost, which depends on whether the suspension of fair-value accounting is temporary
or permanent. If it is permanent, market participants lose a significant degree of transparency
regarding corporate assets and liabilities, and will price securities accordingly. Borrowing costs
will likely increase across the board, and because firms with higher-quality assets may not have
any mechanism to convince the market of this fact, such firms may refrain from participating in
capital markets, thereby reducing market liquidity and also creating adverse selection (where
only firms with lower-quality assets remain in the market), which raises borrowing costs even
more. Moreover, on an ongoing basis, firms will have to maintain larger reserves to achieve the
same credit quality because of the increased risk of their less-transparent portfolios, further
reducing liquidity and increasing borrowing costs.
If the suspension of fair-value accounting is temporary, then there must be a day of reckoning
when firms will have to mark their assets and liabilities to market, and the suspension is merely a
postponement of that eventuality. A postponement is reasonable under two conditions: (1) the
existence of extraordinary circumstances that cause market prices of the firm s assets and
liabilities to deviate significantly from economic value; and (2) the extraordinary circumstances
are temporary and unrelated to the economic value of the firm s assets and liabilities. For
example, suppose a terrorist attack on U.S. soil creates a massive but temporary flight-to-quality,
during which time the value of an insurance company s assets, which are largely invested in
AAA-rated corporate debt, falls precipitously. In this scenario, the flight-to-quality is temporary,
and the decline in the insurance company s assets is largely (although not completely) unrelated
to its economic value, hence a temporary suspension of fair-value accounting may be defensible
since the insurance company is likely to be solvent once the flight-to-quality passes.
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House Oversight Committee Testimony November 13, 2008
However, this argument implicitly assumes that the flight-to-quality is a form of temporary
insanity that should be dismissed or, at the very least, discounted. But if, for example, the flight-
to-quality is not a temporary phenomenon, but rather a change in regime that is likely to last for
years, e.g., because the terrorist event portends ongoing threats that cannot easily be eliminated,
then the suspension of fair-value accounting is delaying the inevitable and interfering with the
appropriate re-pricing of business enterprises under a new economic regime.
Also, the temporariness of impairments to economic value is insufficient justification for
suspending fair-value accounting the condition that the impairment be unrelated to the
economic value of the impaired asset is also critical. The reason is simple: even if an asset s
market value is only temporarily impaired, if the impairment is directly related to the nature of
that asset then it should be taken into account and marked to market. For example, suppose a
bank holds part of its assets in a hurricane insurance company. During an unusually active
hurricane season, the value of these holdings may be temporarily impaired, but this impairment
is directly related to the economic value of the insurance company, and suspension of fair-value
accounting only interferes with the price discovery process.
A more subtle argument for suspending fair-value accounting has been put forward by Plantin,
Sapra, and Shin (2008), who observe that during periods where liquidity is very low, a forced
liquidation of an asset by firm A can depress the market price of that asset, which affects the
value of firm B if it also holds that same asset and is required to mark that asset to market. In
such situations, fair-value accounting inadvertently creates correlation among the assets of many
firms, even those that are not attempting liquidations, and this increased correlation can lead to
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