Marking-to-Market: Panacea or Pandora's Box?

Plantin, G, Sapra, H and Shin, H S (2007) Marking-to-Market: Panacea or Pandora's Box? Working Paper. London Business School IFA Working Paper.

Abstract

Ficial institutions have been at theforefront of the debate on the controversial shift in international standards from historical cost accounting to marktomarket accounting. We show that the tradeoffs at stake in this debate are far from onesided. While the historical cost regime leads to some inefficiences, marking to market may lead to other types of inefficiences by injecting artifical risk that degrades the information value of prices, and induces suboptimal real decisions. We construct a framework that can weigh the pros and cons. We find that the damage done by marking to market is greatest when claims are (i) longlived, (ii) illiquid, and (iii) senior. These are precisely the attributes of the key balance sheet items of banks and insurance companies. Our result therefore shed light on why banks and insurance companies have been the most vocal opponents of the shift to marking to market.