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

Posted: 31 May 2019

See all articles by Urooj Khan

Urooj Khan

Columbia Business School - Accounting, Business Law & Taxation

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Date Written: December 5, 2018

Abstract

I investigate whether fair value accounting can contribute to the banking industry’s systemic risk. I focus on the adoption of SFAS No. 115, which required available-for-sale (AFS) securities to be recognized at fair value with unrealized gains and losses included in equity through accumulated other comprehensive income. SFAS No. 115 increased banks’ regulatory risk because, at the time, calculation of regulatory capital closely conformed with GAAP equity. I find that systemic risk increased following the adoption of SFAS No. 115. Furthermore, following a subsequent regulatory amendment—which excluded unrealized gains and losses on AFS securities from regulatory capital but did not change their GAAP treatment—systemic risk decreased. Taken together, the evidence suggests that fair value accounting has the potential to increase systemic risk through the explicit inclusion of volatile fair value estimates in regulatory bank capital adequacy assessments. I do not, however, find evidence of fair value accounting impacting systemic risk in its information role; that is, by providing information to a bank’s external stakeholders about its financial position and performance. I also show that higher fair value volatility of investment securities, lower bank capital, and larger AFS security holdings increase banks’ marginal contribution to systemic risk. My findings should interest regulators and policymakers as recent regulatory changes in light of Basel III recommendations require unrealized gains and losses on AFS securities to be included in regulatory capital for advanced approaches banks.

Keywords: fair value accounting, systemic risk, available-for-sale securities, prudential AOCI filter, banking, Basel III

JEL Classification: G01, G21, M41

Suggested Citation

Khan, Urooj, Does Fair Value Accounting Contribute to Systemic Risk in the Banking Industry? (December 5, 2018). Contemporary Accounting Research, Forthcoming. Available at SSRN: https://ssrn.com/abstract=3393542

Urooj Khan (Contact Author)

Columbia Business School - Accounting, Business Law & Taxation ( email )

3022 Broadway
New York, NY 10027
United States

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