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.

(more…)