Revisiting valuation practices throughout the business cycle: some symmetry is needed

J. Caruana and C. Pazarbasioglu

Financial Stability Review, 2008, issue 12, 15-22

Abstract: The current crisis exposed weaknesses in the application of accounting standards and gaps associated with the valuation of financial products. During the upturn, the revaluation of assets, build-up of off-balance sheet claims, and booking of unrealised gains obscured risk exposures taken by financial institutions. But as we have learned, when the cycles turn, the downward trends and uncertainties in the value of assets may lead to negative dynamics that may exaggerate the trough of the cycle. This is generally accepted, but we need to be more symmetrical in our approach: increasing valuations in the upturns can also create the incentives, through more profits, compensations and dividends, to purchase more of the appreciating assets and thereby exacerbate the peak. All this raises legitimate questions regarding the role of risk management systems, accounting standards and regulations in creating adequate incentives and conveying information on a financial entity’s risk profi le throughout the business cycle. More fundamentally, it raises questions about whether marking-to-market provides the necessary objective representation or may contribute to mispricing of risk during upturns and injecting artificial risk during downturns and thus distorting the information value of prices. Changing accounting standards at the height of the crisis would risk adversely impacting investor confidence and should be avoided. Furthermore, fair value accounting is the direction to go, but going forward, there is a need to revisit the implications of accounting standards on behavior and incentives, especially during good times, with a view to making possible adjustments to current accounting practices. Inconsistencies of accounting standards with best risk management practices and prudential norms can be very expensive for financial stability. Governance and risk management within financial institutions need to be improved, and supervisors should scrutinise more carefully internal processes and controls, as well as valuation and stress testing methodologies.

Date: 2008
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