Potential Effects of Fair Value Accounting on US Bank Regulatory Capital

Abstract

For many years the regulatory capital of commercial banks in the United States has been based on the book value of assets and liabilities. That has changed with the implementation of Fair Value Measurements in FAS 157. Now banks and regulators must view capital from a Fair Value perspective. This could have a profound adverse affect on commercial banks when interest rates change. Banks that have shifted from "originate and hold" loans to "originate and distribute" loans suddenly may find themselves "undercapitalized," particularly if interest rates rise. Smaller banks that rely on cumulative gap and maturity gap analysis for interest rate risk assessment would expect increases in interest rates to result in increases in net interest income and equity. More sophisticated measures, based upon discounted net cash flow calculations associated with portfolio durations, might show the opposite effect. In addition, as regulators focus more on interest rate loss distributions associated with market risk assessments under economic capital requirements, they may well increase regulator capital requirements at the same time that banks experience a decrease in the Fair Value of their capital. As a result, banks accustomed to maintaining adequate capitalization levels may find it increasingly difficult to do so.