Fair Value Accounting, Illiquid Assets, and Financial Stability

Lucas Mahieux ()
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Lucas Mahieux: Tilburg School of Economics and Management, Tilburg University, 5037 AB Tilburg, Netherlands

Management Science, 2024, vol. 70, issue 1, 544-566

Abstract: In this paper, I analyze the joint design of capital requirements and fair value reporting rules for financial institutions with illiquid assets. I specifically examine 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 private information, whereas Level 2 fair values are only measured with public information. Interestingly, my analysis shows regulators may leave to financial institutions the discretion to report illiquid assets at Level 2 or Level 3. Financial institutions then report at Level 3 only if they have good private information about the assets’ quality. Moreover, prudential rules that only rely on Level 2 fair values may be efficient at solving agency problems within financial institutions but may also decrease financial stability. By contrast, prudential rules that leave to financial institutions the discretion to report illiquid assets at Level 2 or Level 3 while relaxing capital requirements may increase financial stability.

Keywords: fair value; Level 2/3; financial stability; prudential regulation; systemic risk (search for similar items in EconPapers)
Date: 2024
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Persistent link: https://EconPapers.repec.org/RePEc:inm:ormnsc:v:70:y:2024:i:1:p:544-566

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