Fair Value Accounting and ‘Pro-Cyclical’ Economic Behaviour Flashcards
What is meant by “pro-cyclical” behavior?
Pro-cyclical: Amplifying economic trends—upwards in booms and downwards in busts.
Why is fair value accounting said to contribute to pro-cyclical behavior?
FVA Link: When markets rise, fair value increases, boosting bank capital and encouraging more lending; when markets crash, forced write-downs reduce capital, triggering fire sales and further price declines.
Can you give a practical example of FVA’s pro-cyclical effect?
Asset Bubbles: In a rising market, assets are marked up, increasing perceived net worth and fueling further credit expansion. Conversely, sudden price drops force significant mark-downs, leading to margin calls, liquidity shortages, and a downward spiral.
What are some counterarguments regarding fair value accounting and pro-cyclical behavior?
Market Forces: Pro-cyclicality is also driven by investor psychology and credit conditions, not just accounting methods.
Regulatory Environment: Basel capital requirements or central bank policies can exacerbate or mitigate cycles.
Disclosure vs. Decision: Accounting simply reflects market reality; it doesn’t cause it.
What do Laux (2009) and Power (2010) suggest regarding pro-cyclical concerns and FVA?
Laux: Argues we should consider broader systemic factors—FVA may reveal volatility but not necessarily create it.
Power: Points out how reliance on market prices can transform the concept of reliability, potentially feeding into self-reinforcing market assumptions.
Do you personally agree that FVA is pro-cyclical? Briefly state a position.
Yes: It amplifies market swings by tying balance sheet values to volatile market prices.
No: Volatility is inherent in financial markets; fair value merely provides timely information.
Moderate: Some cyclical effect exists, but broader financial regulation and market psychology are bigger drivers.
