Christian Leuz sent me this thought piece today (with Christian Laux, forthcoming in Accounting, Organizations and Society), which provides a nice cool splash of realism on the often-overheated debate on fair value accounting. Perfect timing, given that later today Haresh Sapra presents his own views that fair-value accounting poses some serious risks to the stability of our financial system.

The paper echoes Demsetz’s complaint about the Nirvana Fallacy. Demsetz said:

The view that now pervades much public policy economics implicitly presents the relevant choice as between an ideal norm and an existing ‘imperfect’ institutional arrangement. This nirvana approach differs considerably from a comparative institution approach in which the relevant choice is between alternative real institutional arrangements.

Laux and Leuz argue that the alternative to real institutional arrangement is not necessarily all that different (impairment accounting still reflects market values on the downside), and to the extent that it is different, isn’t all that much better (impairments are typically less timely than fair value remeasurements).  From the paper:

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.

What about the concerns that market prices reflect excessive volatility?

But it is also possible that market reactions are even more extreme if current market prices or fair value estimates are not disclosed to the market. We are not aware of any empirical evidence that investors would be calmer under HCA. Investors are not naïve; they know about the problems, e.g., in the subprime-loan market, and hence will draw inferences even in the absence of fair-value disclosures (and in that case might assume the worst). Thus, lack of transparency could make matters worse. Furthermore, even if investors were to react more calmly under HCA,this may come at the price of delaying and increasing the underlying problems (e.g., excessive subprime lending).

Here I wonder if Laux and Leuz are missing the fact that the overheated debate over fair value accounting is itself empirical evidence of how investors behave.  If investors were not naive, why would we see so many of them hyperventilating over fair value accounting?