In this paper I use simulation techniques to investigate the effects of fair value accounting (FVA) on bank financial stability in volatile market conditions. Using a sample of U.S. banks, assuming a constant asset mix and financial leverage, I find that banks reporting under FVA experience more financial instability (equity contraction) in volatile market conditions, including both temporarily overheated and temporarily distressed conditions. These findings raise questions about the soundness of the current fair value measurement standards which allow fair values to deviate from market prices in illiquid or inactive markets, but make no provisions for fair values in overheated markets, thus, making it possible for opportunistic or myopic managers to maximize the near-term benefit during economic bubbles at the risk of long-term financial instability. Furthermore, I find that the banks appear to have learned from their experiences in market crises, and have become more resilient in sustaining the destabilizing effects of FVA during volatile market conditions.
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