Mark-to-Market, Loan Retention, and Loan Origination

We study the ex-ante efficiency of mark-to-market accounting (MTM) in a loan market by taking into account its real effects on banks’ origination and retention decisions. Despite its benefit of improved valuation accuracy, MTM could reduce the overall efficiency of the economy. The efficiency loss results from the central idea of the paper: the attempt to exploit the information in market price, by adopting MTM, interferes with the market process that generates the information in price. Relative to historical cost accounting, MTM could induce banks to retain excessive exposure to the risk of the loans they originated, damage price discovery in the loan market, and reduce banks’ ex-ante incentive to originate good loans. These results imply an economy with an inefficient risk distribution and a lower overall loan quality, two important factors that have contributed to the current financial crisis.