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The Effect of Fair vs. Book Value Accounting on Banks

by Katrin Burkhardt of Bundesverband Deutscher Banken, and
Roland Strausz of the Free University Berlin

July 3, 2006

Abstract: This paper studies the effect of book versus fair value accounting on a bank's (re)investment behavior, risk of default, investment value, and the need for regulation. Adopting the wide-spread view that fair value accounting increases disclosure and reduces the degree of asymmetric information, we show that fair value accounting increases the liquidity of financial assets. Consequently, it intensifies risk shifting and, therefore, increases the need for regulation and the risk of default. For highly leveraged institutions the increased risk shifting under fair value accounting outweighs an underinvestment effect of book value accounting and ultimately reduces welfare.

JEL Classification: G21, G28, M41.

Keywords: fair value accounting, book value accounting, disclosure, asymmetric information, banking regulation, liquidity.

Previously titled: The Effect of Fair vs. Book Value Accounting on the Liquidity and Investment Behavior of Banks

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