Did fair value accounting contribute to the 2008 financial crisis?

Abstract

The 2008 financial crisis generated a heated debate over the role of fair value accounting (FVA) during the economic downturn. The debate has focused on the financial industry as it makes the most extensive use of FVA in its financial statements. The critics have argued that FVA provisions had exacerbated the crisis by forcing otherwise sound financial institutions to write down their assets to distorted market prices. The written-down prices can become benchmarks for other institutions, thus creating contagion effects within the economy. As the decreases in asset values depletes banks’ regulatory capital, it might force them to sell assets at the distorted prices. The defenders, on the other hand, argue that FVA did not have the effects alleged by the critics. This paper examines both sides of the debate and creates an empirical model to test the effects of fair value gains/losses on bank regulatory capital.

I examine a sample of all US FDIC insured banks with both domestic and foreign offices which issue Call reports, over the period 2007–2011. I find that fair value gains/losses are significant determinants of changes in bank regulatory capital ratios. More specifically, realized gains/losses on AFS and HTM securities, and trading gains/losses are significant determinants of changes in bank capital adequacy as measured by the tangible common equity, the Tier 1 leverage, and the Tier 1 capital ratios. Additionally, unrealized gains/losses on AFS securities are significant determinants of changes in the tangible common equity ratio, but not the Tier 1 leverage ratio, or the Tier 1 capital ratio.

I also find that the statistical significance of my findings does not result in economic significance. Despite the significant negative trends experienced by fair value gains/losses, the capital adequacy ratios remained largely unaffected during the crisis. My findings suggest that FVA had little to no role in amplifying the financial crisis of 2008.