FSR FINANCIAL STABILITY REVIEW OCTOBER 2008 VALUATION AND FINANCIAL STABILITY 109–012 www.banque-france.fr “No part of this publication may be reproduced other than for the purposes stipulated in Article L.122-5.2° and 3° a) of the Intellectual Property Code without the express authorisation of the Banque de France or, where applicable, without complying with the terms of Article L.122-10. of the said code.” © Banque de France - 2008 ISSN 1637-4681 CONTENTS Valuation challenges in a changing environment I-VII CHRISTIAN NOYER, Governor of the Banque de France ARTICLES Should fi nancial institutions mark-to-market? 1 FRANKLIN ALLEN, Wharton School, University of Pennsylvania ELENA CARLETTI, University of Frankfurt Setting the right framework for modern fi nancial markets – Lessons learned from the recent crisis 7 HUGO BANZIGER, Deutsche Bank Revisiting valuation practices throughout the business cycle: some symmetry is needed 15 JAIME CARUANA, International Monetary Fund CEYLA PAZARBASIOGLU, International Monetary Fund Valuation and fundamentals 23 LAURENT CLERC, Banque de France Taking into account extreme events in European option pricing 39 JULIEN IDIER, Banque de France, Université Paris I CAROLINE JARDET, Banque de France GAËLLE LE FOL, Banque de France, Université d’Évry, CREST ALAIN MONFORT, Banque de France, CNAM, CREST FULVIO PEGORARO, Banque de France, CREST Fair value accounting and fi nancial stability: challenges and dynamics 53 SYLVIE MATHERAT, Banque de France How should we respond to asset price bubbles? 65 Frederic S. MISHKIN, Federal Reserve System Regulation, valuation and systemic liquidity 75 AVINASH D. PERSAUD, Intelligence Capital Limited Fair value accounting and fi nancial stability 85 GUILLAUME PLANTIN, London Business School HARESH SAPRA, Graduate School of Business, University of Chicago HYUN SONG SHIN, Princeton University 95 Procyclicality of fi nancial systems: is there a need to modify current accounting and regulatory rules? JEAN-CHARLES ROCHET, Toulouse School of Economics Valuation in insurance and fi nancial crisis 101 PHILIPPE TRAINAR, SCOR Group Bringing transparency to fi nancial reporting: towards an improved accounting framework in the aftermath of the credit crisis 115 DAV I D TWEEDIE, International Accounting Standards Board Improving fair value accounting JOSÉ VIÑALS, Banco de España 121 RÉSUMÉS 131 PUBLISHED ARTICLES 137 SUBSCRIPTION FORM 140 Banque de France • Financial Stability Review • No. 12 – Valuation and fi nancial stability • October 2008 Valuation challenges in a changing environment CHRISTIAN NOYER Governor Banque de France n many respects, the current crisis is about 1| VALUATION FRAMEWORKS valuation. To be sure, factors underlying Iand affecting the crisis are many. Yet, what IN TESTING TIMES is particularly striking is that uncertainty about the true value of complex fi nancial instruments (structured products) undermined global 1|1 Prior to the crisis markets’ confi dence, raised uncertainty about counterparties’ risk positions, and lead to contagion The valuation frameworks in place at the time the across asset classes, markets, and regions. crisis hit last year were the legacy of major efforts, made over the past decade or so, to improve risk Not surprisingly, the crisis has revived a complex measurement and fi nancial reporting for fi nancial discussion on how fi nancial instruments should institutions, as well as solvency regulations for be reported under accounting standards. Still, regulated entities. In many respects, these efforts valuation is not solely about accounting, as the crisis were extensively informed, if not driven, by the showed dramatically. Sound valuation is central to experience with previous crises, an experience internal risk measurement and management, capital which goes as far back as the bond crisis in the requirements, solvency analysis, and more broadly, early 1990s, and which includes landmark episodes fi nancial stability. As such, it is critical both as an such as the Japanese housing and banking crisis or input for the smooth functioning of fi nancial markets the Long-Term Capital Management (LTCM) collapse. and institutions, as well as an output from fi nancial systems in their role of allocating capital effi ciently Improvements in risk management, fi nancial across the economy. In other words, valuation issues reporting and solvency regulations have largely are at the heart of today’s modern, market-based, been concomitant and mutually-reinforcing. and risk-sensitive fi nancial systems. One could conjecture that, had they not occurred, the dislocation that took place last year would very As a presentation of this new issue of the Banque likely have had even greater consequences. de France Financial Stability Review, this overview does three things. It fi rst describes in broad terms Indeed, the widespread use of sophisticated risk the extent to which valuation frameworks have measurement and management methods across the been put to the test by the recent crisis. It then fi nancial industry has raised risk sensitivity and risk highlights that the performances of valuation awareness in the system. Since the mainstreaming, in regimes are linked to those of markets. Finally, the mid-1990s, of risk metrics based on value-at-risk it identifi es consistency, incentives, and the methodologies (VaR), fi nancial institutions have procyclicality of valuation frameworks as the main signifi cantly improved their capacity to identify, issues to be considered. value, and manage the various risks they hold in Banque de France • Financial Stability Review • No. 12 – Valuation and fi nancial stability • October 2008 I Christian Noyer: “Valuation challenges in a changing environment” their balance sheets. Over time, the range of available recent or historical standards), most credit risk measurement techniques has widened; stress-testing and market risk valuation models fail to produce has become more commonplace; integrated estimates commensurate with market reality. These management processes have been set up together shortcomings were sometimes compounded by with dedicated governance structures. It is certainly insuffi ciently robust, comprehensive and disciplined not fortuitous that those fi rms which were using a risk valuation processes. In this respect, excessive broader range of risk measures and had disciplined reliance on ratings for structured products, an risk management processes and governance are also overoptimistic assessment of liquidity risk, the those which avoided signifi cant unexpected losses dangerous reliance on a single source for prices in the current turmoil.1 or on primary market valuation as guides for fair value accounting, an insuffi ciently broad range of In parallel, the move to mark-to-market accounting valuation tools, the use of outdated market data in fi nancial reporting has fostered transparency and inputs and volatility estimates are among the most a more timely recognition of risk exposures, and signifi cant problems revealed by the turmoil. has contributed to sharpening market discipline. The logic underpinning this change is basically that Second, the crisis also revealed that unclear, accurate and meaningful fi nancial statements need to uneven or inadequate disclosure of risk exposures refl ect the value at which balance sheet items could be compounded uncertainty, fuelled market illiquidity bought or sold in current transactions between willing and contributed to depressing asset values. This parties. This, in turn, enables market participants, was most obvious for off-balance sheet vehicles, investors and supervisors to gain a better insight into which were used by regulated entities to offl oad the actual risk profi les of fi nancial institutions. risks, thereby creating an undue sense of reduced exposure. Problems associated with insuffi cient More risk-sensitive solvency regulations have also disclosure were also patent with respect to fostered better market discipline and sound risk valuation practices themselves. The uneven, barely management practices. A fi rst decisive step was comparable disclosures made by fi nancial fi rms achieved when risk sensitivity was introduced in about how they were valuing complex products prudential regulations in 1996. The new Basel II and the margins of error surrounding these points framework will further expand this approach by estimates, especially as markets became illiquid, ensuring that minimum capital charges are more magnifi ed uncertainty about the location of risks closely responsive to changing risks faced by banks, in the system and contributed to bringing some enhancing supervision of actual practices and markets to a halt and spreading risk aversion across contributing to better market disclosure. otherwise well-functioning funding markets. Third, the crisis also exposed the need to clarify some accounting notions that are key to valuing 1|2 A test complex assets at market price. Experience has shown that, for instance, fi nancial fi rms could The crisis is a major test for all valuation frameworks. make substantially different interpretations of what It originated from the uncertainty about the valuation accounting standards meant by “active market” of complex structured credit products, concerns and “distress sale”. When the market functioning about the reliability of ratings, opacity of actual risk is impaired, market participants have to make exposures and the robustness of counterparties’ risk subjective judgments. This could lead to a wide assessment. Based on the experience gained