Question

You have been hired as Risk Consultant at a U.S.-based bank.

The bank is currently reporting its financials using the book value accounting method. The bank is considering an international move in which it can switch to the market value accounting method.

You have been asked to write a 3-page report for the bank`s management. The report should discuss the following:

• What is the difference between book value accounting and market value accounting?
  • How do interest rate changes affect the value of bank assets and liabilities under the two methods? Provide an example that supports your position on this.
• What is marking to market?

Answer 1

The book value

The book value literally means the value of a business according to its books (accounts) that is reflected through its financial statements.

Theoretically, book value represents the total amount a company is worth if all its assets are sold and all the liabilities are paid back.

This is the amount that the company’s creditors and investors can expect to receive if the company is liquidated.

Book value of a company=Total assets−Total liabilities

The Market Value

The market value represents the value of a company according to the stock market.

While market value is a generic term that represents the price an asset would get in the marketplace, it represents the market capitalization in the context of companies.

It is the aggregate market value of a company represented as a dollar amount. Since it represents the “market” value of a company, it is computed based on the current market price (CMP) of its shares.

Market value also is known as market cap. It is calculated by multiplying a company's outstanding shares by its current market price.

Now answer of this part How do interest rate changes affect the value of bank assets and liabilities under the two methods? Provide an example that supports your position on this.

For a Financial institution, a major factor affecting asset and liability values is interest rate changes. If interest rates increase, the value of both loans (assets) and deposits and debt (liabilities) fall. If assets and liabilities are held until maturity, it does not affect the book valuation of the FI. However, if deposits or loans have to be refinanced, then market value accounting presents a better picture of the condition of the FI. For an FI, a major factor affecting asset and liability values is interest rate changes. If interest rates increase, the value of both loans (assets) and deposits and debt (liabilities) fall. If assets and liabilities are held until maturity, it does not affect the book valuation of the FI. However, if deposits or loans have to be refinanced, then market value accounting presents a better picture of the condition of the FI.

Answer to the third part

What is marking to market?
The process by which changes in the economic value of assets and liabilities are accounted to is called marking to market. The changes can be beneficial as well as detrimental to the total economic health of the FI.