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

Abstract

I investigate whether fair value accounting can contribute to the banking industry's systemic risk. I focus on the adoption of Statement of Financial Accounting Standard No. 115 (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.

Implementation the International Financial Reporting Standards as a Moderating Variable of the Relationship of Corporate Governance with Earnings Management

“…This is resulting sense of skeptical of investor to perform investment named liquidity risk. Scott (2012), Kothari and Lester (2012), Khan (2010), Allegret et al (2016), Thalassinos et al (2010Thalassinos et al ( ), (2013Thalassinos et al ( ), (2014Thalassinos et al ( ), (2015, Boldeanu and Tache (2016), Fetai (2015) and Glavina (2015) state that the liquidity risk leads to market value lower than book value. According to Scott (2012) and Politis (2011) and(2012), the impact of using normal value when the liquidity is low the market price constitute main issue of normal values failure.…”

Fair Value Accounting and Earnings Management Using LLP and Realized Gains and Losses: Study in Banking Industry Listed on Indonesia Stock Exchange

“…To measure the use of fair value accounting by banks proxied by FVAT. Following previous research (Bratten et al 2013 (5) loan commitments that are not used as a derivative; (6) of loans and leases that will be sold (Nissim and Penman2007;Khan 2011). If none outlined above are not disclosed in the financial statements, it will be given a value of 0.…”

Investors’ expectations around quantitative easing: does liquidity injection affect European banks equally?

“…It is well known that illiquidity triggers bankruptcies and implies negative externalities (Dewatripont and Tirole, 1993) with a relevant contagion-risk on the entire banking system and a systemic-risk on the entire economic system (Allen & Carletti, 2008;Khan, 2019). In the aftermath of the last financial crisis (2007)(2008)(2009), the regulator reacts to liquidity threats outlining a new ratio, the liquidity coverage ratio (LCR), dedicated to maintaining a reasonable level of liquidity and properly managing risks (Basel III framework).…”

“…Alternatively, large banks could create more liquidity than small banks because they have easier access to the lender of last resort and because they would be the first to benefit from a safety net; (Ratnovski, 2009). Furthermore, well-capitalized banks are perceived as "less risky" by depositors and investors (Khan, 2019), when the lack of capital adequacy triggers (1) a reduction of bank lending (increase of borrowing costs and decrease of credit availability), (2) a deleveraging through fire sales and (3) an increase of risk-shifting incentives (Bushman & Williams, 2015). Some prior studies focus on samples of banks split on several levels of regulatory capital (Bowen & Khan, 2014;Khan, 2019), where they define well-capitalized banks as those that are supposed to have sufficient capital to serve as a buffer from market swings, strengthening the concept of well capitalized banks as "strongly capitalized", and not-well capitalized banks as "poorly capitalized".…”

“…Alternatively, large banks could create more liquidity than small banks because they have easier access to the lender of last resort and because they would be the first to benefit from safety net (Distinguin et al, 2013). Furthermore, well-capitalized banks are perceived as "less risky" by depositors and investors (Khan, 2019), whereas lack of capital adequacy triggers (1) a reduction of bank lending (increase of borrowing costs and decrease of credit availability), (2) a deleveraging through fire sales and (3) an increase of risk-shifting incentives (Bushman & Williams, 2015). Other theoretical arguments highlight the role played by liquidity in the agency relation, where liquidity provides a managerial discretion and misalignment with shareholders' interests.…”