In discussing the potential problems of FVA, it is important to also consider the alternative. Naturally, the
Question:
In discussing the potential problems of FVA, it is important to also consider the alternative. Naturally, the relevant alternative depends on the assets in question. Few would argue that historical cost accounting (HCA) is an alternative for liquid assets (e.g., stocks) in banks’ trading books. But for many, HCA is an alternative for loans, in particular, if they are held to maturity. Similarly, if we were to suspend FVA for illiquid assets in times of crisis as many have suggested, what values would we use instead? Even if one is sympathetic to the arguments against FVA, it does not automatically follow that HCA would be better, although many opponents of FVA implicitly or explicitly assume so. At times, FVA may not provide relevant information, but in many cases, (amortized) historical costs do not provide relevant information either.
Moreover, even when an investor intends to hold financial assets until her retirement, she may still have an interest in the current value of these assets. Why does this logic not also apply to disclosures about a firm’s financial assets? That is, even for assets that are held to maturity (e.g., loans), investors might care about current market values, be it to evaluate past decisions in light of current market conditions or because investors have some doubts that the firm (or bank) can hold these assets to maturity. Similarly, when bank regulators set capital requirements based on expected future losses at the time of the transaction, we would expect them to adjust required capital when expectations about future losses change – and not just when losses are realized. It is surprising that some commentators seem to believe that HCA is a sound basis for capital requirements or that the liquidity of an asset should play no role when market values and liquidity play an important role in determining (ongoing) margin or collateral requirements.5 Aside from highlighting some of the shortcomings of HCA, these examples also illustrate that it is important to be explicit about the presumed goal(s) of accounting when we debate the merits of FVA and other alternatives, such as HCA because their relative merits likely depend on the goal(s) of accounting. Furthermore, take the concern that observed prices may not always reflect true fundamental values and that in those cases marking-to-market is not appropriate. Clearly, it is conceivable that, at times, observed market prices deviate from fundamentals. That is, markets may not be efficient with respect to publicly available information at all times. There are transaction costs and limits to arbitrage, and market prices may be subject to behavioral biases and investor irrationality (e.g., Shleifer, 2000; Barberis and Thaler, 2003). Moreover, a liquidity crunch can affect market prices (e.g., Shleifer and Vishny, 1992).
The important question, however, is how to deal with this problem. Potential market inefficiencies can be addressed in a variety of ways and again HCA is not the only alternative. Historical costs do not reflect the current fundamental value of an asset either. Therefore, it might be better to use market values, even if the markets are illiquid, and to supplement them with additional disclosures, e.g., about the fundamental value of the asset when held to maturity. FVA does not prevent firms from providing additional information, including management’s estimates of fundamental values.6 One might counter this argument with the concern that investors may overlook information in the notes to the financial statements or that they would overreact to fair values based on current market prices despite the disclosure of (higher) fundamental values in the notes. However, we are not aware of any empirical evidence that investors systematically ignore or overlook information in the notes. Having said that, there is a legitimate debate over whether the market fully and correctly impounds financial information in price (e.g., Kothari, 2001). For instance, the market could overreact (e.g., DeBondt and Thaler, 1985).
Statistics for the Life Sciences
ISBN: 978-0321989581
5th edition
Authors: Myra Samuels, Jeffrey Witmer, Andrew Schaffner