RISK SHIFTING AND FAIR VALUE ACCOUNTING IN THE BANKING INDUSTRY

I examine whether and how the improvements in fair value disclosures resulting from the adoption of Statement of Financial Accounting Standard No. 157, Fair Value Measurement,s affect banks’ investment decisions. Using a sample of the largest one hundred publicly-traded bank holding companies, I find that, SFAS 157 does not affect the extent to which banks invest in high or low liquidity risk securities. Further cross-sectional analyses reveal that, following the adoption of SFAS 157m banks with high (low) funding liquidity needs reduce (increase) their holdings of high liquidity risk securities. These findings are consistent with the improved fair value disclosures contributing to mitigating the risk shifting incentives of banks with high funding liquidity needs and having no effect on a liquidity risk arbitrage strategy for banks with low funding liquidity needs. Consistent with the risk overhang hypothesis, I also find that banks with high funding liquidity needs use their discretion in fair value measurements to conceal the losses on their investment securities.