Banks’ Voluntary Adoption of Fair Value Accounting and Interbank Competition∗

We study the role of interbank competition in shaping banks’ incentives to use fair-value accounting voluntarily and the impact of fair-value discretion on banks’ competing strategies. We find that allowing banks discretion to use fair-value accounting may give rise to multiple equilibria in situations where the equilibrium would be otherwise unique. When the profitability in the banking industry is sufficiently large or bank competition is not intense, a “mild” equilibrium stands as the unique equilibrium; when the profitability is sufficiently small or bank competition is very intense, an “aggressive” equilibrium sustains as the unique equilibrium; when the profitability is intermediate or bank competition is moderate, both mild and aggressive equilibria exist. Furthermore, we show factors that may lead to a shift between the two equilibria. The analysis in this study may provide insights and help us to better understand the role of accounting in the recent crisis. ∗We thank Anne Beyer, Yun Zhang, Judson Caskey, and an anonymous reviewer of the 2013 FARS Conference for helpful suggestions to improve this paper, we also thank participants of the 2013 FARS Conference, the 2013 AAA Annual meeting, and the 2013 Junior Theorists Conference for comments.