An Empirical Analysis on the Impact of Fair Value Accounting and Market Illiquidity on Bank Contagion: Application to the Saudi Banking Sector

Abstract

This study aims to test whether fair value accounting is associated with an increase in systemic risk in the banking network. Investigations were also made as to whether the association between fair value accounting and an increase in systemic risk is greater during periods of market illiquidity. Furthermore, examinations as to whether banks that are poorly capitalized or have relatively more fair value assets and liabilities are more likely to be affected by the increase in systemic risk associated with fair value accounting. The results on the first research question indicate that a more fair value-oriented accounting regime is associated with an increase in bank contagion above and beyond the contagion that exists due to trade and financial linkages in the banking industry, i.e., the probability that more banks experience extreme negative returns when the money center banks are performing poorly is higher under a more fair value-oriented accounting regime. To investigate the second research question on whether a more fair value-oriented accounting regime is associated with a greater increase in bank contagion during periods of illiquidity, the sample months were classified into periods of liquidity and illiquidity. It was found that fair value accounting is associated with an increase in bank contagion only during periods of market illiquidity. The findings of this paper should be useful for policy-makers and regulators in weighing the costs and benefits of a fair value oriented accounting regime for banks. The findings of this paper would also be useful to the Saudi Arabian Monetary Agency (SAMA) in weighing the costs and benefits of a fair value oriented accounting regime for banks and deciding whether a) fair value accounting is associated with an increase in systemic risk in the network of banks, b) should fair value accounting rules be suspended or modified, and c) whether fair value is the appropriate measurement and reporting basis for financial instruments when markets are distressed or illiquid.