Book vs. Fair Value Accounting in Banking and Intertemporal Smoothing
OFRC Working Paper No. 2004fe13
32 Pages Posted: 6 Mar 2005
Date Written: September 8, 2004
The aim of this paper is to examine the pros and cons of book and fair value accounting from the perspective of the theory of banking. We consider the implications of the two accounting methods in an overlapping generations environment. As observed by Allen and Gale (1997), in an overlapping generation model, banks have a role as intergenerational connectors as they allow for intertemporal smoothing. Our main result is that when dividends depend on profits, book value ex ante dominates fair value, as it provides better intertemporal smoothing. This is in contrast with the standard view that states that, fair value yields a better allocation as it reflects the real opportunity cost of assets. Banking regulation play an important role by providing the right incentives for banks to smooth intertemporal consumption whereas market discipline improves intratemporal efficiency.
Keywords: Book value, Fair Value, Banking, Intertemporal Smoothing, Overlapping Generations
JEL Classification: D50, G21, M41
Suggested Citation: Suggested Citation