For example, the European Banking Authority (EBA) is developing binding technical standards on a prudent valuation methodology by end-2012. These developments are a significant departure from past practices in reporting bank balance sheets. At present, this prudent valuation information will form part of the regulatory return, which may be publicly disclosed. But in time, it would be desirable if it formed part of banks’ reported annual accounts to maximise investor transparency and consistency. This would parallel the approach used in other realms of public policy to capture economic uncertainty – for example, the “fan charts” for inflation and GDP published by the Bank of England. Bank liabilities and maturity mismatches A second dimension along which banks’ balance sheets are different is the structure of their liabilities. Typically, these have a considerably shorter duration than their assets – in others words, banks engage in maturity transformation. This is one of the main reasons for separate regulatory and resolution rules for banks. But it has a bearing, too, on appropriate accounting rules. To see why, consider a bank with 50-year assets funded by overnight deposits. The bank intends to hold these assets to maturity. Under current rules, holding intent, alongside the characteristics of the assets themselves, is the arbiter of valuation. So those intentions would enable the bank to hold the asset in its banking, rather than trading, book for regulatory purposes. But the liability structure of banks means that holding ability may in practice matter much more than holding intent.

For the stylised bank, its 50-year best intentions could be invalidated within 24 hours. In that event, amortised cost would be a very misleading valuation convention. The bank’s entire asset portfolio ought really to be valued at market (and potentially fire-sale) prices. For a bank with long-maturity illiquid assets, these differences in valuation convention could have a material impact on solvency. They may even be the difference between solvency and insolvency. Had their loan books been marked to market during the crisis, UK banks would have had significantly negative net worth for a protracted period (Chart 2). Most global banks would have been in a similar position. As the maturity of banks’ liabilities was low and falling during this period, this marked-to-market thought-experiment is not as fanciful as it may sound. Three implications follow. First, it underscores the importance of liquidity regulation. This aims to close any maturity mismatch across the balance sheet. For example, the purpose of the net stable funding ratio, agreed as part of Basel III, is to correct mismatches calculated across the whole balance sheet. Second, there is a debate underway internationally about the appropriate criteria for defining the boundary between banks’ trading books and banking books for regulatory purposes. Currently, the regulatory boundary is based on banks’ trading intent. Yet as the stylised example demonstrates, holding intentions may be an economically incoherent basis for valuation. There is a strong economic case for moving away from the existing intent-based convention for differentiating banking and trading books.