The Economic Consequences of Extending the Use of Fair Value Accounting in Regulatory Capital Calculations
54 Pages Posted: 16 Oct 2016 Last revised: 19 Oct 2016
Date Written: October 12, 2016
We investigate the economic consequences of the new regulatory requirement under Basel III to include unrealized fair value gains and losses on available-for-sale (AFS) securities in the calculation of regulatory capital. Regulators argue that such an inclusion would result in greater regulatory discipline, while critics contend that it would increase regulatory costs. Using a comprehensive sample of U.S. banks, we find that news indicating an increased likelihood of this rule being implemented lead to negative market reactions that are strongly associated with the relative amount of unrealized fair value gains and losses. This finding is consistent with the regulatory cost argument. Moreover, exploiting a differences-in-differences approach we also find that banks affected by this provision reduce their investment in riskier illiquid AFS securities relative to unaffected banks. These results suggest that extending the use of fair values for regulatory purposes leads to a reduction in ex ante risk taking.
Keywords: Banks, Fair Value Accounting, Prudential Regulation, Regulatory Capital
JEL Classification: G21, M41
Suggested Citation: Suggested Citation