Fair Value Accounting and the Law of Unintended Consequences

You’re probably familiar with what’s often called the Law of Unintended Consequences— regulations designed to address one issue but which also make impacts in often unrelated realms.

Assistant Professor Michael Iselin has uncovered a case of the law in action with research into the Statement of Financial Accounting Standards 157 (SFAS 157). The standard requires companies to disclose how they calculate fair values—and establishes a three-level hierarchy for those values. “Level 1 and Level 2 are observable market prices,” says Iselin. “Level 3 is where there is no observable price, and managers need to estimate the fair value.”

After SFAS 157 passed, research documented that equity market investors began to discount Level 3 assets. “If a firm disclosed it had $100 of a Level 3 asset, the equity market treated it as if it were only worth $95,” says Iselin. “It’s difficult to value those securities, and the market wanted to protect against the possibility that the actual value was less than $100.”

That led Iselin to wonder about the potential impact of SFAS 157 on managerial decisions. His thesis: “If investors were discounting Level 3 securities,” he explains, “it might make sense for bank managers to shift investment portfolios away from Level 3 assets and toward Level 1 or Level 2 assets.” That’s where the unintended consequences emerged.

The research confirmed that. “Public bank managers reduced Level 3 asset holdings more than private bank managers,” Iselin notes. “At private banks there is no public stock market, so the pressures from equity market discounting were not as strong for these banks.”

“SFAS 157 changed the type of information bank managers had to disclose,” Iselin says. “That change caused public bank managers to reallocate their investment portfolios.”

“Regulators need to understand this,” he adds. “Even relatively small changes in disclosure requirements can lead to changes in managerial behavior at firms subject to the new standards.”

This feature originally appeared as part of the Discovery at Carlson magazine.