Accounting Discretion, Market Discipline and Bank Behaviour: Some Insights from Fair Value Accounting

Abstract

Using quarterly data on FAS 157 fair value disclosures for US bank holding companies from 2008 to 2013, we test whether capital ratios and the effects of market discipline differ according to extent and nature of assets recognized under Level 3 standards. These standards offer management significant discretion for measuring fair values, potentially reducing bank transparency and affecting market perceptions about bank risk. We find limited evidence that capital ratios are lower at institutions engaging in Level 3 trading activities for given risk levels, consistent with opportunistic behaviour. We also find that market discipline, as measured by whether an institution has a US stock exchange listing or dependence on short-term, uninsured funding sources, is effective in moderating this behaviour. At these institutions capital ratios are higher, consistent with there being a direct (ex ante) disciplining effect on bank behaviour.

Keywords: Banking, market discipline, accounting discretion, regulatory capital ratios

JEL Classification: G21, G28, G32