Increasing evidence has been reported by researchers regarding the amplifying negative quality of fair value-oriented accounting regime. Critics have blamed the fair value accounting for amplifying the recent subprime crisis and causing a financial meltdown in the US. This paper investigates the contagion (negative) effect of introducing fair value accounting for commercial banks in India and its relationship with changes in the banks’ Non-Performing Assets (NPA) ratio. It is found that there is evidence to suggest significant increase in the NPA ratios of the banks due to the introduction of fair value-oriented accounting of the banks’ assets. The analysis suggests that increased bank contagion associated with fair value accounting is more likely to spread to banks that are inherently weak (in respect of capital adequacy and other parameters).

The critics of fair value accounting, including policy makers, auditors, and industry professionals claim that fair value accounting has created the vicious circle of falling asset prices and the financial meltdown of 2008 (Hughes and Tett, 2008; Johnson, 2008; and Rummell, 2008). Several experts in the US have blamed fair value accounting for amplifying the effect of the subprime crisis on the following credit crunch, which is considered by many as the worst economic crisis since the Great Depression (Ryan, 2008a). Speaking at the Securities Exchange Commission (SEC) panel on ‘mark-to-market accounting and the market turmoil’ following the subprime crisis, William Isaac, former Chairman, Federal Deposit Insurance Corporation (FDIC), blamed mark-to-market accounting for causing the financial meltdown that followed the subprime crisis (Katz, 2008). Also, two recent analytical papers, Cifuentes et al. (2005) and Plantin et al. (2008), have shown that mark-to-market accounting has the potential of exacerbating the contagion (the spread of market shocks—especially, on the downside—a process observed through co-movements in stock prices) across banks, thereby increasing the systemic risk in the banking industry. Systemic risk is the risk of breakdowns in an entire system, as opposed to the collapses of individual parts or components (Kaufman and Scott, 2000).

In view of these claims, linking fair value accounting and contagion effect in banks, we attempt an exploratory study of testing as to how far the contagion effect of a prospective introduction of fair value accounting in India would be visible on the bank’s loans and advances assets portfolio in terms of changes in the ratio of Non-Performing Assets (NPA) to total assets in these banks.

The rest of the study is organized as follows: the next section explains as to what is fair value accounting and its procyclicality feature at work, followed by a brief survey of evidence elsewhere on how the accounting system causes contagion. The subsequent section reports on fair value estimation for assets and liabilities of commercial banks in India, including measurement of variables used in the regressions later. Further, the regression results and their interpretation are provided. The final section offers some concluding remarks.

Bank Management Journal, Indian Banks, Asset Liability Management, Data Filtering, Least Absolute Deviation, Decision-Making Group, Commercial Banks, Ordinary Least Square, Banking Industry, Kenyan Banks, Least Squares Regression, Mutual Fund Industry, Linear Programming, Financial Markets, Capital Required Adequacy Ratio, Public Sector Banks.