At the macro-economic level, concern has been expressed that greater use of fair values could have a procyclical impact. Banks’ assets might be marked up in booms, as perceived credit risk declined, so boosting banks’ capital base and capacity for further lending. However, for the concerns about intensifying economic cycles to be realised two linkages would need to operate. First, the impact on bank capital would have to increase the volume of bank lending and, second, the increase in bank lending would need to have significant implications for real activity. Neither linkage can be taken for granted, and in any case discretionary policy action, whether monetary or prudential, by the authorities may mitigate any pro-cyclical effects. As I have indicated, we do, however, need to avoid accounting rules which introduce spurious volatility. An example, to which I will return in a moment, is the hedge accounting under IAS 39. The “mixed attribute” model The drawbacks of fair values in some contexts have led to widespread support in the banking industry for retaining the current “mixed attribute” accounting approach. While IAS 39 requires trading instruments, derivatives and many securities to be measured at fair value, bank loans generally continue to be measured at historic cost. However, the debate about IAS 39 has highlighted some difficulties with this mixed approach as it is presently formulated. The area of greatest difficulty has proved to be hedges which straddle the two measurement bases, where so-called hedge accounting comes into play.
“Own-credit risk” arises from the “fair value option” in IAS 39, which allows an entity to fair value not only its assets but also its liabilities. On that basis, the value of liabilities, including deposits, should fall as an entity’s creditworthiness deteriorates. Here we find a difference of perspective between shareholders on the one hand and debt holders, including depositors (and by extension regulators and central banks), on the other. In an economic sense, given that the equity interest in a company cannot fall below zero, as net worth diminishes debt holders bear a growing proportion of reductions in asset values. But this approach is in tension with the understandable concern of bank depositors and regulators about the capacity of banks to repay liabilities at par when due, and who therefore want measures of net worth constructed on that basis. A separate issue arises in arriving at a fair valuation of sight deposits. For such deposits, there is typically a difference between the contractual maturity (zero) and the behavioural maturity (the time over which sight deposits are held in practice). Since the interest paid on such deposits is almost always less than the market discount rate, once any maturity greater than zero is admitted the fair valuation of the deposit will be less than par. But once again, depositors are likely to be more interested in the financial strength of a bank assessed on the basis that deposits are ascribed their full  BIS Review 71/2004  1  nominal value.