Debate has intensified in recent years on the advantages and disadvantages of moving towards a full mark-to-market accounting system for banks and insurance companies. The debate has been heated by moves by the International Accounting Standards Board (IASB) and the US Financial Accounting Standards Board to harmonize accounting standards across countries. Proponents contend that mark-to-market accounting has the advantage of reflecting the relevant value of financial institution balance sheets, allowing regulators, investors and other users of accounting information to better assess their risk profile. Opponents counter that mark-to-market accounting leads to excessive and artificial volatility, especially when regulatory standards such as bank capital ratios are tied to reported accounting numbers.mark-to-market accounting, accounting standards, financial markets

Elena Carletti

Finn Poschmann

Franklin Allen

English

Research Papers in Economics

e-brief
Marking to Market for Financial Institutions:
A Common Sense Resolution
By
Franklin Allen, Elena Carletti and Finn Poschmann
Debate has intensified in recent years on the advantages and disadvantages of moving towards a full mark-to-market
accounting system for banks and insurance companies. The debate has been heated  by moves by the International
Accounting Standards Board (IASB) and the US Financial Accounting Standards Board to harmonize accounting
standards across countries. Proponents contend that mark-to-market accounting has the advantage of reflecting the
relevant value of financial institution balance sheets, allowing regulators, investors and other users of accounting
information to better assess their risk profile. Opponents counter that mark-to-market accounting leads to excessive
and artificial volatility, especially when regulatory standards such as bank capital ratios are tied to reported
accounting numbers. If so, the reported liquidity and solvency of financial institutions could be driven by temporary
fluctuations that did not reflect the fundamental value of assets and liabilities. 
Which side is right? It depends on the state of financial markets. If financial markets operated perfectly, fair
value, or more specifically mark-to-market accounting, would indeed be best: market prices would accurately
reflect fundamental value, which is equal to the discounted present value of a stream of future earnings.
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February 27, 2009
 One currently vexing question is whether, in valuing assets and liabilities on
financial institutions’ balance sheets, market prices provide the best available
estimate of value or if, in times of crisis, using market prices could lead to 
serious distortions. 
 In most circumstances, market prices reflect future earning power and should be
used; at other times, such as in financial crises when liquidity is scarce and price
information is sparse, market imperfections imply that they should not. 
 In crises when liquidity constraints affect market prices, model-based and historic
cost valuations may provide helpful information. The rest of the time, and in
particular when asset prices are low because expectations of future cash flows
have fallen, mark-to-market accounting should be used instead.
An earlier version of this paper (Allen and Carletti, 2008b) formed part of the Banque de France’s October 2008 Financial Stability
Review. The authors thank readers of previous drafts, while absolving them of responsibility for remaining errors.
1 Discounted present value applies a discount rate, based on the cost of capital, to expected future cash flows to express them in terms
of current prices.2 Providers of liquidity have the alternative of investing in high return, but less liquid assets, whose returns accrue over the long term. However,
there is an opportunity cost to holding liquidity, because it has a lower return than long assets; for financial institutions to be willing to supply
liquidity, they must be able to profit. If nobody held liquidity then when banks and intermediaries sold long-term assets to acquire liquidity
their price would collapse to zero. This would provide an incentive for some institutions to hold liquidity since they can acquire assets very
cheaply in these situations. In equilibrium, prices will be bid up to the level where the profit in these situations where banks and intermediaries
sell is sufficient to compensate the providers of liquidity for all the other situations where they do not use the liquidity and simply bear the
opportunity cost of holding it. In other words, asset prices are low in the situations where there is an aggregate shortage of liquidity and some
banks and intermediaries need liquidity (Allen and Gale, 2007).
market value of an institution’s assets falls below the market value of its liabilities in this sense, it will not be able to meet all of
its obligations. mark-to-market accounting would indicate this shortfall to regulators, investors, depositors and other
interested parties, and they could take action accordingly. 
Many people have argued that financial markets are effectively perfect and complete. However, in times of crisis it appears
they are not. 
Allen and Carletti (2008a) analyses the effects of using mark-to-market accounting when financial markets are imperfect.
In times of financial crisis, the interaction of institutions and markets can lead to situations where asset prices in markets do
not reflect the discounted value of future cash flows accruing to the assets. Rather, asset prices reflect the amount of cash or
liquidity available to buyers in the market. If mark-to-market accounting is used, then the volatility of asset prices directly
affects the value of banks’ assets used for regulatory purposes. This could lead to contagion and force banks into insolvency
even though, assuming that liquidity issues are transient, they would be fully able to cover their commitments if they were
allowed to continue to operate until the assets matured. In contrast, with historic cost accounting, which generally prices
assets at their acquisition cost, this problem does not compromise the solvency of banks: using historical cost accounting for
regulatory purposes could prevent crises that would occur under mark-to-market accounting. 
That mark-to-market accounting could be distortionary and generate “artificial” contagion is due to imperfections in the
supply of liquidity. In a world of perfect and complete markets, risk management ensures that a bank or intermediary has the
correct amount of liquidity in every situation. With perfect and complete markets it is possible to use a full set of derivatives
and other securities (or equivalently dynamic trading strategies) to ensure liquidity is available when it is needed. 
In contrast, when markets are imperfect because they are incomplete, institutions sell assets when they need liquidity.
Asset prices are then determined by the total available liquidity, or in other words by the “cash in the market.” It is necessary
that some financial institutions hold liquidity and stand ready to buy assets when they are sold. But then they are not
compensated for the cost of providing liquidity in every situation, as they would be with complete markets.
2
For low asset prices to occur when there is a shortage of liquidity does not require there to be informational problems.
However, informational problems, such as we have seen recently, can exacerbate price declines. If buying institutions, in
addition to bearing the opportunity cost of holding liquidity, need to expend significant resources to evaluate the assets they
are purchasing, equilibrium prices will be even lower. Then prices must be low enough to cover the cost of due diligence.
This is particularly important for securitizations of subprime mortgages and is consistent with the large fall in their prices in
the current crisis.
There are advantages and disadvantages of mark-to-market accounting versus historic cost accounting: neither system is
perfect, and each works in some circumstances but not others (see Box 1). What is crucial is that users of accounting
information, such as regulators and investors, have information that allows them to understand what is happening and how
this should affect their actions. mark-to-market values are useful and should certainly be disclosed. However, there needs to
INDEPENDENT REASONED RELEVANT
| 2 e-briefbe additional information to allow users to identify the extent to which falls in asset prices are due to market conditions, such
high demand for liquidity, and the extent to which they are due to changes in discounted expected future cash flows.
What information that is easily available can be used for this purpose? The IASB promulgates the International Financial
Reporting Standards that apply to companies in the European Union/European Economic Area, among other countries, and in
Canada from 2011 on. The approach for determining the fair values of financial instruments as outlined in IAS 39 and the
United States’ FAS 157 are similar to each other and to current Canadian accounting principles.
However, FAS 157 is more specific (International Monetary Fund 2008, chapter 2, Annex 2.1). It specifies three levels:
1. Level-one valuations, which are to be used if available, are determined from observable prices in liquid markets. 
2. Level-two valuations are based on market inputs such as quoted prices for similar items in active markets, quoted prices for
identical or similar items in inactive markets, and other inputs that are observable or derived from or corroborated by
observable market data, such as interest rates and yield curves, volatilities, prepayment speeds and default rates. These are
to be used if level one valuations are not available. 
3. Finally, level-three valuations, which are to be used when level-one and level-two valuations are not available, are based on
managers estimates of unobservable inputs, usually discounted expected future cash flows, and require disclosure of
assumptions. For example, estimating fair value for mortgage-backed securities would require assumptions concerning default
rates and loss ratios, which would determine the expected values of future cash flows accruing to the security holders.
These valuation methods should give very similar results most of the time. In such cases there is no point in disclosing anything
other than level-one valuations based on observable prices in liquid markets as is currently done. 
INDEPENDENT REASONED RELEVANT
e-brief /3
The recent crisis, which started at the end of July 2007,
provides an illustration of imperfect markets where some
asset prices do not reflect fundamentals. For instance,
some banks have written down the AAA-rated super senior
tranches of collateralized debt obligations by 30 percent or
more because of a fall in their market prices (Tett 2008).
If this change in price was due to deterioration in
fundamentals then it would be necessary to believe that the
ultimate percentage loss would be 38 percent. This would
be justified, if, for example, three-quarters of households
with subprime securitized mortgages defaulted and price
declines continued so that the loss given default ratio was
50 percent. This seems, however, implausible given that no
AAA-rated tranches of subprime-mortgage-backed
securities (MBS) had defaulted at that time and, as the
Bank of England also estimated, there should not be a 
future default even with a continued decline in US house
prices (Giles and Tett, 2008). This suggests that factors
other than future discounted cash flows have driven prices.
A good example where historic cost accounting failed,
where mark-to-market would probably not have, is the
1980s’ Savings and Loan Crisis in the United States. Then,
the fall in the prices of the assets was due to a collapse in
oil prices (fundamentals), and the expected future cash
flows from many properties in Texas and other oil
producing states fell drastically. Historic cost accounting
allowed banks to hide the extent of their problems for a
significant period of time. Mark-to-market accounting
would have led to a much quicker recognition and
resolution of the problem, because it would have reflected
the fundamental decline in the present value of future cash
flows available to service the loans. 
Box 1: When Market Prices Depart from Fundamentals, and When They Do Not| 4 e-brief
INDEPENDENT REASONED RELEVANT
In times of crisis, however, the three methods can give very different values. An alternative would be to also report level-three
valuations if they differ significantly from level-one (or level-two) valuations. A threshold for triggering the reporting of both could
be a difference of 5 percent, for example. In such circumstances, it may also be helpful to report historic cost values, because
these do not require extensive assumptions. 
Reporting multiple values would alert regulators, investors and other users to the fact that they need to investigate more
carefully whether the institutions are insolvent and unable to meet their future obligations. If they are otherwise solvent, regulators
should typically exercise forbearance, in that they should allow banks to not fully write down the value of their assets according to
market conditions, avoid artificial volatility and its consequent solvency impairment when regulatory ratios are tied to reported
accounting numbers. This would help avoid the procyclicality problem fair value accounting may otherwise cause, as there would
be no need for banks to raise further capital.
Conclusion
Mark-to-market works well and reflects the true underlying situation most of the time. However, in crisis times when there is a
shortage of liquidity, mark-to-market values do not reflect future earning power and cannot be used to assess the solvency of
financial institutions. In such cases, historic cost accounting can provide a better indication of true value. However, historic cost
accounting has the drawback that it misses declines in value that are caused by deterioration of discounted expected cash flows, as
the proponents of mark-to-market accounting suggest. 
Our solution to this problem is to adapt mark-to-market accounting using easily available information. When model-based
valuations based on plausible assumptions differ significantly from market-based valuations, both types of valuation together with
traditional historic cost valuations should be provided. This will signal to the users of information that extra caution is warranted.
While not perfect, this system will be an improvement over the current one. References:
Allen, Franklin, and Elena Carletti. 2008a. “Mark-to-market accounting and liquidity pricing.” Journal of Accounting and Economics,
45 (2-3), 358-378. http://finance.wharton.upenn.edu/~allenf/download/Vita/Allen-Carletti-MMA-200706-final.pdf.
––––. 2008b. “Should financial institutions mark-to-market?” in F S R – October 2008 – Valuation issues at the heart of the current crisis.
Banque de France Financial Stability Review. http://www.banque-france.fr/gb/publications/rsf/rsf_102008.htm.
Allen, Franklin, and Douglas Gale. 2007. “Understanding Financial Crises.” New York and Oxford: Oxford University Press, Clarendon 
Lectures in Finance.
Giles, Chris, and Gillian Tett. 2008. “Bank of England sees credit hope.” Financial Times. May 1.
International Monetary Fund. 2008. Global Financial Stability Report. Chapter 2, April.
Mackintosh, Ian. 2008. “Fair value difficult to define in a changing market.” Financial Times. May 22.
Tett, Gillian. 2008. “Why triple-A prices are out of sync with fundamentals.” Financial Times. May 2.
This e-brief is a publication of the C.D. Howe Institute.
Franklin Allen is Nippon Professor of Finance; Professor of Economics, Co-Director, Financial Institutions Center, Wharton School,
University of Pennsylvania; Elena Carletti is Professor, European University Institute; Finn Poschmann is Vice President, Research,
C.D. Howe Institute.
For more information call 1-416-865-1904.
This e-brief is available at www.cdhowe.org.
Permission is granted to reprint this text if the content is not altered and proper attribution is provided.
INDEPENDENT REASONED RELEVANT
e-brief /5

Bank of England sees credit hope.” Financial Times.

Fair value difficult to define in a changing market.” Financial Times.

is Nippon Professor of Finance; Professor of Economics, Co-Director, Financial Institutions Center,

Mark-to-market accounting and liquidity pricing.”

Should financial institutions mark-to-market?”

Understanding Financial Crises.”

Why triple-A prices are out of sync with fundamentals.” Financial Times. May 2. This e-brief is a publication of the C.D.

Marking to Market for Financial Institutions: A Common Sense Resolution

Marking to Market for Financial Institutions: A Common Sense Resolution

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