Fair Value Accounting, Prudential Regulation and Financial Contagion

Abstract

This paper examines how fair value accounting can create financial contagion among banks and therefore increase bank regulators' costs of protecting insured depositors. Prior research mainly focuses on the economic consequences of marking down, whereas I contribute to the literature by providing a novel trade-off of marking up. On the one hand, by marking its assets up, a healthy bank obtains adequate capital to absorb a failing bank which would otherwise be liquidated in a less efficient secondary market, thereby saving regulators' costs. On the other hand, the otherwise healthy bank becomes more leveraged and thus may face excessive default risk after this merger, leading to financial contagion and increased overall costs for regulators.