If an entity’s creditworthiness deteriorates, financial liabilities would be marked down to fair value and a gain would be recorded in the entity’s profit and loss statement. In the most dramatic case, an insolvent entity might appear solvent as a result of marking to market its own deteriorated credit risk.
To address these concerns, the Basel Committee recommended certain restrictions on the fair value option, such as disallowing the marking to market of credit risk of the institution’s own outstanding debt and prohibiting the fair value option for illiquid financial instruments.