“Taking Diversity Into Account”: Real effects of accounting measurement on asset allocation

In the wake of the financial crisis, accounting issues have caught the attention of both economists and regulators. Fair value accounting has indeed been charged of amplifying the procyclicality of the banking system. Real effects of accounting are therefore to be taken into consideration when discussing the issues raised by the crisis. We develop a theoretical model to study what the real effects of accounting on financial institutions’ investment decision are. Doing so, we show that fair value accounting may incentivize banks to underinvest in long-term risky assets, while historical cost accounting may incentivize them to invest too much in those assets. At first sight, bank accounting thus appears as a choice between bad and worse. We show that this is not necessarily the case. More precisely, if financial institutions are subject to different accounting rules depending on their time horizon – i.e. long-sighted financial institutions are subject to historical cost accounting while shorter-sighted financial institutions are subject to fair value accounting – the inefficiencies associated with both accounting rules may be softened.