Banks' Discretionary Use of Fair-Value Accounting, Capital Requirement Regulation, and Bank Lending

Abstract

This paper examines banks' accounting choices between fair-value and historical-cost accounting when reported accounting information is used for capital requirement regulation. In choosing fair-value relative to historical-cost, banks must consider potential benefits of additional lending in good times against potential cost of a smaller lending or even insolvency in bad times. If the lending return is inelastic to aggregate lending, a higher capital requirement reduces fair-value accounting usage. However, if the lending return is elastic to aggregate lending, a higher capital requirement encourages the usage of fair-value accounting when the initial capital ratio is low. Our analysis also provides some policy implications. We find mandating a uniform fair-value accounting method is socially desirable when the capital requirement is extremely tight, and mandating a uniform historical-cost method is socially optimal when the capital requirement is extremely loose. When the capital requirement is intermediate, allowing discretion is socially optimal.

Keywords: banking, fair value, accounting, capital requirement, historical cost

JEL Classification: D7, D8