The contribution of bank regulation and fair value accounting to procyclical leverage

Abstract

Our analysis of how banks' responses to asset price changes can result in procyclical leverage reveals that, for banks with a binding regulatory leverage constraint, absent differences in regulatory risk weights across assets, procyclical leverage does not occur. For banks without a binding constraint, fair value and bank regulation both can contribute to procyclical leverage. Empirical findings based on a large sample of U.S. commercial banks reveal that bank regulation explains procyclical leverage for banks relatively close to the regulatory leverage constraint and contributes to procyclical leverage for those that are not. We also show that fair value accounting does not contribute to procyclical leverage.

Banks’ Financial Reporting and Financial System Stability

“…Two accounting research papers, Amel‐Zadeh, Barth, and Landsman [] and Laux and Rauter [], examine the association between the proxies for banks’ use of fair value accounting and their leverage procyclicality, as defined by Adrian and Shin []. Amel‐Zadeh, Barth, and Landsman (Laux and Rauter) use banks’ fair value components of comprehensive income (unrealized net gains on AFS securities) to proxy for their use of fair value accounting.…”

“…Laux and Rauter [] find that changes in banks’ average risk weights of assets have a much weaker average effect on banks’ leverage growth than do Amel‐Zadeh, Barth, and Landsman []. Laux and Rauter further find that this effect is significant only for a narrowly constructed sample: commercial banks with greater than 20% fair value assets whose balance sheets expand.…”

“…It is unclear what differences in the research designs of Amel‐Zadeh, Barth, and Landsman [] and Laux and Rauter [] drive the studies’ differing results regarding the primary economic driver of banks’ leverage procyclicality. The simplest explanation is that the alternative drivers examined are correlated, making the results sensitive to sample and model specification.…”

“…Amel‐Zadeh, Barth, and Landsman [] also show that growth in assets with lower risk weights is more positively associated with leverage growth.…”

Does Fair Value Accounting Exacerbate the Procyclicality of Bank Lending?

“…This article is related to the emerging literature on the relation between bank accounting and financial system stability . Laux and Rauter [] and Amel‐Zadeh, Barth, and Landsman [] find that fair value accounting does not explain procyclical bank leverage. While these two studies focus on bank leverage and liabilities, my article focuses on the procyclicality of the asset side.…”