Fair Value Accounting, Illiquid Assets, and Financial Stability

Abstract

Prudential regulation relies on asset values measured using fair value accounting standards. However, determining fair values of illiquid assets is difficult because doing so involves judgment and estimation. This paper examines how prudential regulation aimed at solving agency problems affects financial institutions' incentives to use Level 2 versus Level 3 fair value reporting, as well as financial stability. Crucially, Level 3 reporting allows financial institutions to use their noisy private information, whereas Level 2 fair values are measured with public information. My analysis shows regulators optimally leave to bankers the discretion to report illiquid assets at Level 2 or Level 3. Interestingly, bankers report at Level 3 only if they have good private information about the assets' quality. Moreover, relative to Level 3 reporting, Level 2 reporting increases systemic risk, because it relies on public information. Thus, prudential rules relying on precise Level 2 fair values are a double-edged sword: they are efficient at solving agency problems within financial institutions but decrease financial stability. The paper reconciles the conflicting empirical evidence on the link between fair value accounting and financial stability.