Financial Markets and Institutions (2-downloads)

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M I N I - C A S E

Mark-to-Market Accounting and 

the 2007–2009 Financial Crisis

The controversy over mark-to-market accounting has

made accounting a hot topic. Mark-to-market

accounting was made standard practice in the U.S.

accounting industry in 1993. The rationale behind

mark-to-market accounting is that market prices pro-

vide the best basis for estimating the true value of

assets, and hence capital, in the firm. Before mark-to-

market accounting, firms relied on traditional 

historical-cost (book value) basis in which the value 

of an asset was set at its initial purchase price. The

problem with historical-cost accounting is that fluctua-

tions in the value of assets and liabilities because of

changes in interest rates or default are not reflected

in the calculation of the firm’s equity capital. Yet

changes in the market value of assets and liabilities—

and hence changes in the market value of equity 

capital—are what indicates if a firm is in good

shape, or alternatively, if it is getting into trouble and

may therefore be more susceptible to moral hazard.

Mark-to-market accounting, however, is subject to

a major flaw. At times markets stop working, as

occurred during the 2007–2009 financial crisis. The

price of an asset sold at a time of financial distress

does not reflect its fundamental value. That is, the

fire-sale liquidation value of an asset can at times be

well below the present value of its expected future

cash flows. Many people, particularly bankers, have

criticized mark-to-market accounting during the recent

financial crisis episode, claiming that it has been an

important factor driving the crisis. They claim that the

seizing up of financial markets has led to market

prices being well below fundamental values. Mark-to-

market accounting requires that the financial firms’

assets be marked down in value. This markdown cre-

ates a shortfall in capital that leads to a cutback in

lending, which causes a further deterioration in asset

prices, which in turn causes a further cutback in lend-

ing. The resulting adverse feedback loop can then

make the financial crisis even worse. Although the crit-

icisms of mark-to-market accounting have some valid-

ity, some of the criticism by bankers is self-serving.

The criticism was made only when asset values were

falling, when mark-to-market accounting was painting

a bleaker picture of banks’ balance sheets, as

opposed to when asset prices were booming, when it

made banks’ balance sheets look very good.

The criticisms of mark-to-market accounting led to a

congressional focus on mark-to-market accounting that

resulted in a provision in the Emergency Economic

Stabilization Act of 2008 that required the SEC, in

consultation with the Federal Reserve and the U.S.

Treasury, to submit a study of mark-to-market account-

ing applicable to financial institutions. Who knew that

accounting could even get politicians worked up!

have instituted regulations to protect financial institutions from competition. These

regulations have taken two forms in the United States in the past. First were restric-

tions on branching, which are described in Chapter 19, which reduced competition

between banks, but were eliminated in 1994. The second form involved preventing

nonbank institutions from competing with banks by engaging in banking business,

as embodied in the Glass-Steagall Act, which was repealed in 1999.

Although restricting competition propped up the health of banks, restrictions on

competition also had serious disadvantages: They led to higher charges to consumers

and decreased the efficiency of banking institutions, which did not have to compete

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