Mark-to-Market Regulatory Accounting When Securities Markets are Stressed: Lessons from the Financial Crisis of 2007-2009

Abstract

While market prices can be useful tools for bank regulation, recent theoretical work argues that reliance on prices can be counterproductive when secondary markets are stressed and illiquid. Evidence from the financial crisis unearthed by Bhat, Frankel and Martin (2011) provides empirical validation of these arguments. Though Bhat et al. do not fully acknowledge it, their findings suggest that forcing banks to count liquidity-induced unrealized losses in securities holdings against regulatory capital destroys value and exposes bank creditors, including taxpayers, to more risk. Policy makers contemplating greater regulatory reliance on market prices ignore these findings at their peril.

Keywords: Bank Regualtion, Banking, Financial Institutions, Financial Accounting

JEL Classification: G21, G28, E53, M41