Did Fair-Value Accounting Contribute to the Financial Crisis?

Christian Leuz is the Joseph Sondheimer Professor of International Economics, Finance and Accounting at the University of Chicago Booth School of Business.

In a recently released working paper co-authored with Christian Laux entitled Did Fair-Value Accounting Contribute to the Financial Crisis? we investigate whether there is merit to the claim that fair-value accounting exacerbated the severity of the 2008 financial crisis. The main allegations are that fair-value accounting contributes to excessive leverage in boom periods and leads to excessive write-downs in busts. The write-downs deplete bank capital and can set off a downward spiral, as banks are forced to sell assets at “fire sale” prices, which in turn can lead to contagion as prices from asset-fire sales become relevant for other banks.

We begin our analysis by explaining in more detail how pure mark-to-market accounting can cause problems in a crisis. We then outline extant accounting rules for banks’ key assets, which is different from pure mark-to-market accounting. Extant rules allow banks to deviate from market prices under certain circumstances. In addition, not all fair value changes enter the computation of banks’ regulatory capital. We then examine possible mechanisms through which fair-value accounting could have contributed to the financial crisis, and conclude that it is unlikely that fair-value accounting added to the severity of the financial crisis.

The crisis started when housing prices declined and delinquency and default rates increased. Uncertainty and information asymmetry dried up the refinancing and repo markets, which were crucial for investment funds, investment banks, and several large bank holding companies. While downward spirals and asset-fire sales did occur during the crisis, there is little evidence that these events occurred as a direct result of fair-value accounting or that the problems would have been less severe under historical-cost accounting. Banks were highly levered during the boom and relied heavily on collateralized repurchase agreements, where the amount of debt that can be obtained depends on the market value of the assets used as collateral, regardless of accounting convention. Moreover, investors would have been concerned about banks with substantial (subprime) mortgage exposure once the problems in the mortgage market were apparent, even if banks had not written down mortgage-related assets and simply reported their historical cost. Thus, investment funds, investment banks or bank holding companies that relied heavily on short-term borrowing and had substantial subprime exposures would have faced major difficulties regardless. In fact, less transparency about losses and exposures could have made matters worse.

For bank holding companies, accounting numbers also play an important role for regulatory capital requirements. We therefore examine the impact of fair value accounting on income and regulatory capital requirements for bank holding companies. The evidence suggests that the impact of fair value changes on bank income and regulatory capital was limited. For the majority of bank holding companies the fraction of assets reported at fair value with a direct impact on income and regulatory capital is rather small. In addition, adjustments in the determination of regulatory capital and flexibility in the accounting rules provide several safeguards against downward spirals and the use of potentially distorted market prices. We show that banks made ample use of that flexibility. For instance, many banks with substantial real-estate exposure and large trading portfolios used cash-flow-based models to value their mortgage-related securities by the third or fourth quarter of 2007. Moreover, we find little empirical evidence that banks’ reported fair values suffered from excessive write-downs or undervaluation in 2008; if anything, the evidence points in the opposite direction.

The full paper is available for download here.

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