Historical cost versus fair value accounting in banking: Implications for supervision, provisioning, financial reporting and market discipline

The issue of historical cost accounting (HCA) versus fair value accounting (FVA) is a fruitful area for research, when examined under the prism of the intersection between bank capital and bank risk management, and the regulators' and the standard setters' approach towards the purposes of HCA and FVA. This paper debates the applicability and enforceability of two diametrically opposite approaches to bank accounting, their effects on transparency, reliability and the associated regulatory (official) discipline. It analyses the usefulness, relevance and reliability of these two contrasting accounting frameworks for the measurement, recognition and disclosure of bank financial instruments in the banking books (particularly loans and loan-loss provisions). It touches upon the benefits and costs associated with the application of these accounting frameworks. It suggests that the principled advantages of turning to full FVA (FFVA) for banks are outweighed by the pragmatic and practical difficulties in operationalising such an accounting treatment. The introduction provides for an overview of current developments concerning the introduction and application of FVA in banks' banking books as a response to the limitations of the mixed accounting approach followed currently. The first section analyses the usefulness of HCA, as well as the regulators' support of a differentiated HCA. The second section, the main part of this paper, focuses on the impact of FFVA on banks' capital, bank risk management and financial reporting, again with reference to the banks' banking books. An analysis of the merits of FFVA provides grounds for its enforceability and potential alignment with the banking books by comparison generated from the first section. The paper concludes that fair values have quite different attractions and dangers for regulators as opposed to accounting standard setters.