"Fair Value Losses and Systemic Risk during the Financial Crisis"

Abstract (current version) :

We analyze the effect of other-than-temporary impairments (OTTI), a measure of fair value (FV) losses on investment securities, on ΔCoVaR, the increment in the quantile of the banking sector return due to bank distress, a measure of systemic risk, during the financial crisis of 2008. Using a hand-collected quarterly panel of OTTI for publicly traded bank holding companies from 2007 to 2010, we find that (i) OTTI contributed to individual bank risk and systemic risk, but slightly less so than loan losses ; (ii) the change in OTTI rule, following the pressure from the banking industry helped reduce systemic risk ; (iii) the majority of banks enjoyed a modest decrease in systemic risk, but for some, especially poorly capitalized banks with large portfolios and large unrealized losses, the reduction in systemic risk was sizable. Our results suggest that FV losses are a contributor, but not the single source of systemic risk, and that the OTTI rule change was at least partly effective in reducing systemic risk during the financial crisis. Our findings further suggest that, after the change of fair value rule, the credit portion of OTTI, which affects regulatory capital is more important for bank-specific risk, whereas the non-credit portion, which does not affect regulatory capital, matters more for systemic risk.