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Ms. Jodi G Scarlata, Mr. Juan Sole, and Alicia Novoa
In light of the uncertainties about valuation highlighted by the 2007-2008 market turbulence, this paper provides an empirical examination of the potential procyclicality that fair value accounting (FVA) could introduce in bank balance sheets. The paper finds that, while weaknesses in the FVA methodology may introduce unintended procyclicality, it is still the preferred framework for financial institutions. It concludes that capital buffers, forward-looking provisioning, and more refined disclosures can mitigate the procyclicality of FVA. Going forward, the valuation approaches for accounting, prudential measures, and risk management need to be reconciled and will require adjustments on the part of all parties.
Ms. Jodi G Scarlata, Mr. Juan Sole, and Alicia Novoa

I. I ntroduction Since the 2007 market turmoil surrounding complex structured credit products, fair value accounting and its application through the business cycle has been a topic of considerable debate. As the illiquidity of certain products became more severe, financial institutions turned increasingly to model-based valuations that, despite increased disclosure requirements, were nevertheless accompanied by growing opacity in the classification of products across the fair value spectrum. Moreover, under stressed liquidity conditions, financial