Facing a market meltdown, some regulators have pulled the plug on trading, as in Russia and Brazil. More have shut short sellers in their rooms. One of the few things not yet suspended is mark-to-market accounting. A temporary suspension is an attractive idea, on the face of it. Marking assets to market was always expected to lead to volatility: that was the price of transparency. But what happens when there is no market, or only an illiquid one?
For most of the past year, there have been few buyers for many bank assets. That has sent derivatives whose prices were based on them, such as credit default swaps, all over the place. The result has been “procyclicality”, as banks simultaneously recognised losses. This then triggered fire sales, which depressed asset prices further, and so on in a vicious spiral that can be as bad for stock markets as it is for banks. They did things differently in the old days – such as a few years ago. When banks held loans to maturity, regulators could turn a blind eye to technical insolvency and let banks recapitalise themselves slowly through earnings. That is what happened in the 1980s Latin American debt crisis and in 1990s Japan. Now, by contrast, a bank’s ability to operate depends on it being able to sell its assets overnight and have something left over for shareholders. If it cannot do that, it is bust.
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