Investment and Contagion Tradeoffs between Fair Value and Historical Cost Accounting

We examine the effects of fair-value accounting (FVA) and historical-cost accounting (HCA) regimes on the ex-ante financing of projects by external investors. We formulate a model highlighting the relative merits and demerits of each accounting regime, in particular the sub-optimal continuations under the HCA regime and contagion-induced sub-optimal liquidations under the FVA regime. We show that under homogeneous beliefs about future cash-flows, FVA regime is superior with greater ex-ante financing, even during periods of high market illiquidity, when the failure of some banks leads to adverse spillovers on surviving financial institutions. However, if disclosures under the FVA regime leads to distorted beliefs about future success probabilities, ex-ante financing may suffer under the FVA regime, and it may no longer be superior relative to the HCA regime. In this setting we also analyze the impact on ex-ante financing of (i) ex-post redemption gates, which restrict the extent of investor liquidation under stress, and (ii) government guarantees, which limit the spillovers ex post but may incentivize excessive risk-taking ex ante.