How Accounting, Credit, and Risk Standards Create Risk
Financial practitioners and regulators largely agree that the Global Financial Crisis, and other recent crises, was compounded by the use of International Financial Reporting Standards. These standards emphasize marking the value of assets to their current market price. The accountant shorthand for this practice is “mark-to-market.” The application of IFRS’s standard that governs the loan-loss provisions for financial institutions and extends mark-to-market meant that when asset prices fell sharply in 2007 and 2008, financial institutions were forced to raise capital to set against the deterioration in their asset/liability ratio. To raise cash quickly they had to liquidate assets. This depressed asset prices, which in turn caused an increase in computed risk, a need for more capital and more selling. A vicious cycle ensued that was driven primarily by these valuation conventions rather than an actual need for readily available cash.