Fair value or historical cost : the case of the efficiency of the safety and soundness regulation in the banking sector

When historical cost is used, the incomes are smoothed in a way that delays the recognition of the financial institutions lessening solvency, especially in the case of fixed rate loans when market rates are decreasing. We study the case of Credit Lyonnais which had the opportunity to transfer bad loans in a special purpose entity. We noticed that French financial institutions managed the problem in a way that smoothed the losses. At the opposite, in the USA, during the same period, bad assets were depreciated, regardless the institutions became insolvent. Our intent is not to list all the possible accounting choices, but to explain the following inconsistency: French financial institutions acted in a very different manner from American ones. In France, historical record was given preference over current valuation, attaching importance to the value of time. This choice was opposed to the usual rule of prudence. In the USA, the market was the main component for calculating the value of the assets. In both cases, the necessity to meet regulations and the role of the State played a great part in the accounting choices made.