Does Fair Value for Financial Instruments Constitute a New Channel of Contagion

Introduction Accounting aims to reflect as realistically as possible financial situation of enterprises. The increasing complexity of economic world, development and globalization of financial markets and gradual domination of ideology of shareholder value have made accounting based on historical values increasingly inadequate. Anxious to better match realities of this new world, authorities responsible for enacting accounting rules have gradually abandoned rule of historical cost to prefer fair value. This concept was rooted in two major accounting standards: U.S. GAAP and IFRS. The initiative was made by accounting standards FAS 107, issued in 1991 and FAS 119 issued in 1994 related to disclosures about derivatives and fair value of financial instruments. These two standards have provided requirement to indicate fair value of these instruments in notes to financial statements. In 1998, FAS 133 has confirmed valuation at fair value accounting as a model assessment by imposing it on all derivatives initially and subsequently, whatever their nature and intent with which they are acquired or issued. SFAS 157, Fair value measurements, defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at measurement date. In IAS, we meet frequently concept of fair value in evaluation of employee benefits, intangible assets, revaluation of fixed assets, business combinations, securities portfolio, etc. Among these standards, IAS 39, which deals with financial instruments, is a revolution. In fact, financial instruments represent a large portion of assets and liabilities of enterprises, in general, and financial institutions, in particular. They also play a central role in efficiency of financial markets. Therefore, IAS 39 has important implications for risk management companies, and introduces changes in ratios of bank solvency. That's why this standard still raises several questions, particularly since collapse of subprime crisis in United States. The financial crisis of 2008 highlighted problems of application of fair value when market is illiquid. Critics focus on procyclicality of fair value and resulting contagion effects (Barth and al. 1995; Allen and Carletti 2008; Laux, and Leuz 2009). Based on results of these studies, we direct our research towards analysis of impact of measuring financial instruments at fair value. Specifically, main issue of our research revolves around existence of a possible effect of measuring financial instruments at fair value on banking contagion during periods of illiquidity. We seek to answer following question: Is measurement of financial instruments at fair value has an effect on bank contagion, in general, and during periods of illiquidity, in particular? In order to answer to this question, we study empirical validity of two concerns: First, we examine whether fair value accounting for financial instruments is associated with spread of banking contagion. Then, we estimate impact of market illiquidity on this association. To achieve this, we develop two models. The first model, based on stock returns, is a multinomial logit model. The second model is a static panel model where risk substitutes return as a dependent variable. This paper is structured as follows. Section 1 introduces topic and highlights thesis statements. Section 2 reviews relevant theoretical and empirical literature and formulates hypotheses. Section 3 specifies models and measurement of variables. The sample selection and data sources are presented in section 4. Section 5 presents results and discussion of empirical tests. The final section offers some concluding remarks. …