There have been many advances in the field of credit management. Mark to market accounting is one such innovation. Mark to market accounting is now commonly used by many organizations to manage their credit risks. In this article, we will understand what the concept of mark to market is and how it helps in managing credit risks.

What is Mark To Market?

Mark to market is a way of recording and valuing the loan assets on the balance sheet of the lender. Traditionally, loans made by lenders were held on the books at book value. However, there was a problem with this approach. The book value does not reflect the decreased credit quality over a period of time. Hence companies often valued their investments at a higher value even though they were being traded at a lower value in the market.

Mark to market accounting was created as a solution to help resolve this problem. Mark to market simply means that the value of the asset on the balance sheet of the lender is changed periodically to reflect the new market realities. For instance, if a bond was purchased for $100 but its present market value is $90, then the company will be forced to adjust the $100 value to $90. As a result, the net worth of the company will be reduced by $10!

Before implementing mark to market accounting, a time period has to be decided when the valuation will be updated. For instance, companies generally decide to mark the value of their positions to the market at the end of each trading day. The price which will be used for valuation also has to be clearly defined. For instance, the closing ask price at the end of the day will be used for valuation.

Advantages of Mark to Market

There are several known benefits of using the mark to market approach. Some of these benefits are as follows:

1. Accurate Reporting: When it comes to credit risk management, timing is everything! This means that if a company is able to detect a negative exposure at the earliest, they have a better chance of managing it. This is the biggest benefit of mark to market accounting. It provides real-time updates to senior management about the quality of credit which is being held by them. This helps companies take appropriate corrective action and prevents them from losing money.

2. Managed Exposure: Companies often create credit limits to manage their credit exposure. However, these credit limits are not as useful if they do not take into account the current values being traded. Mark to market accounting makes it much more easier to manage exposures. Companies can notice the debtors whose credit quality is being decreased. They can use different approaches to limit exposure to these debtors. Also, it provides data which the company can later use to understand the correlation between different types of debt.

3. Early Detection: Traditional credit management is reactive in nature. This means that companies only start taking action after a negative credit event has occurred. On the other hand, mark to market is proactive. It closely tracks the credit quality and puts the company in a position wherein they don’t have to react to credit events but instead they can predict negative credit events.

Disadvantages of Mark to Market

The mark to market accounting model has also faced several criticisms from the financial community. Some of them have been listed below:

1. Adds to the Panic and Extravagance: The mark to market accounting model is often criticized for creating bubbles. This is because it accentuates the feelings of fear and greed in the market. This is because when the market goes down because of speculative activities, companies are forced to recognize the losses on their balance sheet. The recognition of this loss creates pressure on the company to liquidate their positions in order to cut the losses. However, if many companies try to do so, prices fall down further.

   Hence, mark to market is criticized for creating a downward spiral. It faced this criticism during the 2008 crisis. The opposite of this is also true. When this is an upward movement in the market, mark to market also forces investors to recognize their gains. The recognition of these gains makes them excessively bullish and further accentuates the upward trend in the market.

2. Prices do not Reflect Liquidity: Another problem with mark to market accounting is that for many assets the markets are not that liquid. Hence, even though the price may be quoted on the market, the company may not be able to actually liquidate the asset at that price. In such cases, the mark to market valuation may simply be misleading.

3. Mark to Model: For some other assets, there might not be any available market to take reference prices from. This is often the case for complex derivatives. In such cases, prices are derived by marking them to a mathematical model instead of an actual market. The problem here is the assumption that the investor will be able to liquidate the asset at a price suggested by the model. Also, this method is open to manipulation. If the assumptions in the model are tweaked, then the value can be changed.

It would be fair to say that mark to market is a valuable instrument which if used correctly can aid in credit risk management. However, it is important for companies to be aware of the possible risks and ensure that they are avoided.