The last time we had an entire session focused on fair value accounting, our stated intent was primarily to discuss recent evidence on the value relevance of fair value accounting.  It didn’t take long for the conversation to turn toward questions of whether fair value accounting was destabilizing and/or pro-cyclical.

This week, University of Chicago’s Haresh Sapra will lead a discussion on exactly that topic.  (4pm ET Tuesday, April 21st).  You can find details on getting to office hours here, and read below the fold for some background.

Haresh recommends we take a look at the following papers:

The first paper is ‘thought piece’ paper based on some fairly technical analytical work.  But the basic flavor is one that appeals very much to me, as it looks at the feedback loops that fair value accounting can lead to.  Haresh and his co-authors use the example of a swaying footbridge (London’s Millenial Bridge) to get the basic idea across.

Pedestrians on the bridge react to how the bridge is moving. When the bridge moves from under your feet, it is a natural reaction to adjust your stance to regain balance. But here is the catch. When the bridge moves, everyone adjusts his or her stance at the same time. This synchronized movement pushes the bridge that the people are standing on, and makes the bridge move even more. This, in turn, makes the people adjust their stance more drastically, and so on.

In other words, the wobble of the bridge feeds on itself. When the bridge wobbles, everyone adjusts his or her stance, which makes the wobble even worse. So, the wobble will continue and get stronger even though the initial shock (say, a small gust of wind) has long passed.

What does all this have to do with accounting standards and financial markets? Financial markets are the supreme example of an environment where individuals react to what’s happening around them, and where individuals’ actions affect the outcomes themselves. The pedestrians on the Millennium Bridge are rather like modern banks that react to price changes, and the movements in the bridge itself are rather like price changes in the market. So, under the right conditions, price changes will elicit reactions from the banks, which move prices, which elicit further reactions, and so on.

A key point, which Anne Beatty made to me during a recent phone call, is that it isn’t enough to ask whether fair value accounting provides sufficiently relevant and reliable information.  Even if it does, it still might send us all tumbling into the Thames.

Join us for what promises to be a fascinating discussion!