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Costs and Benefits of Fair Value Accounting : Evidence from the Crisis

Policy changes in the last decade have codified the reporting, and expanded the use, of fair value accounting under US GAAP. We build a model of banks’ discretionary fair value reporting decisions that involves a tradeoff between the benefit of recognizing high value assets and the cost of higher future volatility. The model predicts a positive correlation between the likelihood of reporting at fair value and a bank’s capital ratio, and further, that this correlation should decline with increasing macroeconomic stability. Using quarterly panel data on fair value reporting from the Compustat Bank database from 2008-2012, we find strong support for both of these hypotheses. Our results illustrate and quantify the degree to which banks use discretion inherent in GAAP fair value accounting to mitigate declines in asset values in bad times. This channel explains 37% of the variation in the use of fair value across banks and over time in our sample, attenuating concerns over the contribution of fair value to the crisis.