Mary Barth and Wayne Landsman recently posted a paper that discusses how the financial crisis happened and what role financial accounting had in it. I really enjoyed their discussion of fair value accounting. I think it is a very clear explanation of why people blame fair value accounting and why fair value accounting actually isn’t to blame.

The basic argument tying fair value accounting to amplified procyclicality is that auditors required banks to write down affected assets to unrealistically low values as reflected by ABX index prices. Because the Financial Crisis caused a drop in liquidity, ABX index prices allegedly reflected distressed prices rather than prices from an orderly market. Bank managers contended that ABX prices, being artificially low relative to the bank managers’ perceived asset values, caused unnecessarily large impairment charges. That is, impairment charges would have been lower had bank managers been permitted to use their personal assessments of value, and the economy would have suffered a less severe downturn.

Although, in principle, an “excessive” fair value-related impairment charge could have amplified procyclicality of bank asset prices, we believe this is unlikely for two reasons. First, this claim can only apply to those bank assets that were either measured at fair value or for which fair values apply when determining impairment. The proportion of bank assets for which this is the case is limited. Laux and Leuz (2010) reports that during the 2004 to 2006 period banks held approximately of 50% of their assets in loans and leases, which are not subject to fair value accounting and are not impaired to fair value. Although, for the 14 largest US commercial banks, Shaffer (2010) reports the decline in Tier 1 capital during the Financial Crisis arising from impairments of loans averaged 15.6%, those impairments were based on an incurred loss model and not on fair value. Therefore, as discussed in section 6, although impairments of loans, i.e., loan loss provisioning, during the Financial Crisis likely had procyclical effects, fair value accounting played no role relating to loans.

In other words, there was a downward spiral in loan values, but fair value accounting played no role in it because loan values are not calculated using fair value. They are calculated using the incurred loss model.

The authors go on to explain that fair value accounting may have played some small role in the devaluation of other assets, however, bank regulators apply a prudential filter to neutralize some fair value gains and losses when calculating Tier 1 capital requirements. In fact, “Prudential filters neutralized the effect on Tier 1 capital of some fair value losses and the larger effect on Tier 1 capital arose from loan losses that were not determined using fair value.”

The authors also discuss the role that asset securitization, derivatives, and loan loss provisioning played in the financial crisis. The paper is forthcoming in the European Accounting Review.