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Thus Finance Professors Christian Laux and Christian Leuz in their article “ Did Fair-Value Accounting Contribute to the Financial Crisis?” (2009) conclude that although there were downward spirals or asset-fire sales in certain markets in 2008, there was “little evidence that these effects are the result of fair-value accounting…. Mark-to-market accounting rules do not require banks to mindlessly value assets based on “fire sale prices.” In fact the accounting rules have numerous provisions allowing flexibility in valuations, of which many banks made extensive use in the period prior the financial crisis of 2008.Īs a result, careful studies have shown that accounting rules played no significant role in the 2008 financial crisis. Quite apart from the folly of suggesting that banks should cook their books to present a false picture of their actual financial soundness, the fundamental premise of Jenkins’ argument is factually incorrect. In this way, the illusion that the banks were in sound financial shape could have been preserved a little longer, in the hope that somehow or other the real problem of the huge housing bubble and its associated derivatives would miraculously resolve itself with no cost to the economy. The government, Jenkins argues, should have changed the accounting rules and let banks keep assets on their books at valuations that were a multiple of their mark-to-market value. Hence mark-to-market accounting caused the 2008 global financial meltdown. Yet, the argument goes, the whole downward spiral is needless because in 2008 the original capital assets were not as worthless as their value as shown by mark-to-market accounting. That's because prices from asset-fire-sales of one bank become relevant as counter-part assets or as comparators for the assets of other banks. As banks are forced to sell assets at fire-sale prices, this in turn can lead to contagion to the financial soundness of other banks. Forcing banks to value assets at market prices can set off a downward spiral. However capital assets that lose their value in the marketplace when liquidity is tight might not be as worthless as their current market price indicates. Given that banks are required to keep certain amounts of capital on hand for a rainy day, when capital assets lose their value once the rainy day comes, banks must then take steps to increase their capital to get it back to a safe level.
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Jenkins’ argument is a familiar one, rather like, “A dog ate my homework.” It goes like this. The object of the accounting rules is to ensure that everyone can understand the actual financial situation of an enterprise, particularly a bank, rather than being presented with an impenetrable morass of assets with historical values that have no relation to their current value today. The rules that Jenkins is referring to are the rules known as “fair-value” or “mark-to-market” accounting by which banks and others are required to value assets on their books at their current value, not at the price at which they were bought.