The financial valuation crisis The inherent limits to taming unstable markets

The 2007-9 global financial crisis exposed fundamental problems in firms’ valuation approaches and the regulations that bolstered them. Rather than ensuring prudent behavior, regulatory reliance on banks’ risk models, credit ratings, and market-based accounting practices contributed to both the financial boom and the subsequent bust. In response, policymakers set out to fix firms’ valuation practices and to develop a ‘macroprudential’ policy framework to mitigate boom-bust patterns. However, in spite of a flurry of changes, progress on the reforms has been limited in precisely those domains where it seemed most necessary. What explains this?
In this PhD-thesis, I argue that this lack of progress stems from an underlying problem: valuation practices do more than just measure financial risks more or less accurately – they shape them. While valuation practices may at one point in time be conducive to financial stability, their widespread adoption may overtime significantly alter market functioning, thereby contributing to instability. This means that there is no clear link between valuation approaches and financial stability. This introduces a major problem for policymakers, as rules governing valuation practices themselves shape financial markets in unexpected ways. Public prescriptiveness might mandate widespread use of deficient valuation routines, stimulating regulatory caution. Empirically, I show how this ambiguity has obstructed sweeping reforms in the European Union in key regulatory domains: accounting standards, credit ratings, capital and liquidity regulation, and macroprudential policy. In all these domains, policymakers embraced incremental reforms for want of something better.