Regulatory Treatment of Changes in Fair Value and the Composition of Banks' Investment Portfolios

43 Pages Posted: 21 Dec 2017

See all articles by Michael Iselin

Michael Iselin

University of Minnesota - Twin Cities - Department of Accounting

Jung Koo Kang

Harvard Business School

Joshua Madsen

University of Minnesota - Twin Cities - Carlson School of Management

Date Written: December 19, 2017

Abstract

In their implementation of Basel III, U.S. bank regulators are again including changes in the fair value of available-for-sale (AFS) debt securities in Tier 1 capital, but only for the largest U.S. banks. This paper investigates a potential impact of expanding this regulation by examining bank investment decisions in the 1990's when changes in the fair value of AFS debt securities were included in regulatory capital for all banks. Using a matched sample difference-in differences research design, we find evidence that low-capitalized banks reduced their investments in more volatile asset classes (e.g., corporate bonds, non-agency MBS) and increased their investments in less volatile asset classes (e.g., treasuries and municipal bonds) after changes in fair value were included in regulatory capital. We also find that low-capitalized banks change their holdings of these asset classes in the opposite direction after regulators subsequently excluded changes in fair value from regulatory capital. These findings inform regulators worldwide regarding a possible consequence of Basel III. We also contribute to prior research by suggesting that changes in maturity and credit risk around the passage of SFAS 115 (Beatty 1995; Hodder, Kohlbeck, and McAnally 2002) were partially obtained by changing the composition of asset classes within banks' investment portfolios.

Keywords: Fair Value Accounting, SFAS 115, Basel III, Banks, Investment Decisions

JEL Classification: M41, M48, G18, G21

Suggested Citation

Iselin, Michael and Kang, Jung Koo and Madsen, Joshua, Regulatory Treatment of Changes in Fair Value and the Composition of Banks' Investment Portfolios (December 19, 2017). Available at SSRN: https://ssrn.com/abstract=3090548 or http://dx.doi.org/10.2139/ssrn.3090548

Michael Iselin

University of Minnesota - Twin Cities - Department of Accounting ( email )

271 19th Avenue South
Room 645 Mgt. Econ. Building
Minneapolis, MN 55455
United States

Jung Koo Kang

Harvard Business School ( email )

Boston, MA 02163
United States

Joshua Madsen (Contact Author)

University of Minnesota - Twin Cities - Carlson School of Management ( email )

19th Avenue South
Minneapolis, MN 55455
United States

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