Abstract :
Fundamentaleconomicprinciplesprovidearationaleforrequiringfinancialinstitutions
to usemark-to-market,orfairvalue,accountingforfinancialreporting.Therecent
turmoilinfinancialmarkets,however,hasraisedquestionsaboutwhetherfairvalue
accountingisexacerbatingtheproblems.Inthispaper,wereviewthehistoryand
practiceoffairvalueaccounting,andsummarizetheliteratureonthechannelsthrough
whichitcanadverselyaffecttherealeconomy.Weproposeanewmodeltostudythe
interactionofaccountingruleswithregulatorycapitalrequirements,andshowthat
even whenmarketpricesalwaysreflectfundamentalvalues,theinteractionoffairvalue
accountingrulesandasimplecapitalrequirementcancreateinefficienciesthatare
absentwhencapitalismeasuredbyadjustedbookvalue.Thesedistortionscanbe
avoided,however,byredefiningcapitalrequirementstobeprocyclicalratherthanby
abandoningfairvalueaccountingandtheotherbenefitsthatitprovides.
