Fair Value Accounting and Financial Contagion: the Effect of Marking up

Abstract

This paper examines how fair value accounting can create financial contagion by allowing financially healthy banks to mark up their assets to fair value. Prior research has primarily focused on the economic consequences of marking down, whereas this study contributes to the literature by highlighting a novel trade-off of marking up. On one hand, a healthy bank obtains additional regulatory capital by marking up its assets, which enables it to acquire an insolvent bank that would otherwise be liquidated in an inefficient secondary market. On the other hand, the possibility of acquiring another bank may coordinate banks to raise more deposits ex ante. As a result, the failure of the insolvent bank can trigger the healthy bank's failure even if it would have survived without the acquisition, leading to financial contagion and systemic bank failures. I demonstrate that due to this trade-off, marking up may decrease social welfare and is therefore undesirable.

Keywords: Fair Value Accounting, Financial Contagion, Capital Regulation, Coordination

JEL Classification: G21, G28, M41, M48