Paper #771

Title:

Book vs. fair value accounting in banking and intertemporal smoothing

Authors:

Xavier Freixas and Dimitrios P. Tsomocos

Date:

September 2004

Abstract:

The aim of this paper is to examine the pros and cons of book and fair value accounting from the perspective of the theory of banking. We consider the implications of the two accounting methods in an overlapping generations environment. As observed by Allen and Gale(1997), in an overlapping generation model, banks have a role as intergenerational connectors as they allow for intertemporal smoothing. Our main result is that when dividends depend on profits, book value ex ante dominates fair value, as it provides better intertemporal smoothing. This is in contrast with the standard view that states that, fair value yields a better allocation as it reflects the real opportunity cost of assets. Banking regulation play an important role by providing the right incentives for banks to smooth intertemporal consumption whereas market discipline improves intratemporal efficiency.

Keywords:

Banking, shocks, insurance, intertemporal, Overlapping Generations Equilibrium

JEL codes:

E44, G21

Area of Research:

Finance and Accounting

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