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.

To the extent that asset prices are over-inflated, so too are the recorded profits of the banks. During the downswing, fair value principles are rolled back. Potential losses are then hidden from view. Today, some of the uncertainty around global bank valuations stems from the difficulty in gauging these losses, obscured by provisioning practices in banking books. Regulators and investors alike fear the fog created by such forbearance. In sum, accounting rules in general, and fair value principles in particular, appear to have played a role in both over-egging the financial upswing and elongating the financial downswing. They have tended to over-emphasise return in the boom and under-emphasise risk in the bust. That is not a prudent approach. Indeed, it is a pro-cyclical one. We need accounting rules for banks which are crisis-neutral, valuation conventions for all seasons. What accounting regime might best deliver this robustness? A reasonable starting point would be to recognise the clear differences between bank and non-bank balance sheets, in  3  2  Bernanke and Lown (1991). BIS central bankers’ speeches  particular valuation uncertainty associated with assets and maturity mismatch associated with liabilities. Bank assets and valuation uncertainty Banks’ asset portfolios are not just larger and more complex than for non-financial companies. The business of banking is predicated on banks’ capacity to screen and monitor these assets more accurately than capital markets. Banks serve as a “delegated monitor” for investors.4 This means the risks and uncertainties around the valuation of bank assets are fundamentally different than for non-financial firms.