Does Fair Value Accounting Contribute to Systemic Risk in the Banking Industry?

Abstract:     
Critics have blamed fair value accounting for amplifying the subprime crisis and for causing a financial meltdown. It has been alleged that fair value accounting has created a vicious circle of falling prices, thereby increasing the overall risk in the financial system. In this paper, I investigate whether fair value accounting is associated with an increase in the risk of failure of the banking system as a whole. I find that the extent of fair value reporting is associated with an increase in contagion among banks. The increase in bank contagion is most severe during periods of market illiquidity. Further, my cross-sectional analyses suggest that increased bank contagion associated with fair value accounting is more likely to spread to banks that are poorly capitalized or have a relatively higher proportion of fair value assets and liabilities.

Number of Pages in PDF File: 51

Keywords: Fair Value Accounting, Systemic Risk, Banking, Financial Crisis

JEL Classification: G21, M41, M44, G33

working papers series