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

• In Event: Bank Regulation

Abstract

After more than twenty years, changes in the fair value of available-for-sale (AFS) debt securities will again be included in regulatory capital per Basel III. This paper investigates the potential impact of this regulation by examining bank investment decisions in the 1990's when changes in the fair value of AFS debt securities were temporarily included in regulatory capital. 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) when fair values were included in regulatory capital and that banks change these holdings in the opposite direction when regulators subsequently excluded changes in fair value from regulatory capital. We contribute to prior research and document the mechanism whereby banks changed the maturity and credit risk of their securities portfolio after the passage of SFAS 115.

Authors

• Michael Iselin, University of Minnesota-Minneapolis

• JungKoo Kang, USC

• Joshua Madsen, University of Minnesota