Fair Value Accounting, Transparency, and Financial Stability

Prudential regulation of financial institutions relies on asset values measured based on accounting standards. This paper examines how this regulation affects financial institutions' incentives to use Level 2 versus Level 3 fair value reporting and how their endogenous choice affects systemic risk and the informativeness of financial institutions' financial statements. Crucially, Level 3 reporting allows financial institutions to use their private information, whereas Level 2 fair values are measured using publicly observable inputs. My analysis of the Level 3 reporting externalities highlights an interesting tradeoff between transparency and financial stability. Relative to Level 2 reporting, Level 3 reporting reduces the consistency and comparability of financial statements but can decrease systemic risk. Furthermore, manipulation makes Level 3 reporting less desirable, which may in turn increase systemic risk. The model reconciles the conflicting empirical evidence on the role of fair value accounting during the 2007-08 financial crisis, and provides new policy implications