Tainted Portfolios: How Accounting for Other-Than-Temporary Impairment Restricts Security Sales

• In Event: Fair Value Accounting

Abstract

The recent financial crisis and the ensuing recession have heightened concerns surrounding fair value accounting’s role in inducing contagion, particularly the fair values of investment securities at banks. Critics assert that a drop in the market price of an illiquid security can trigger pro-cyclical selling and further price reductions in the presence of fair value accounting, reducing the market value of the security below the economic fundamentals. However, U.S. GAAP does not use a full fair value system for investment securities, but rather, banks consider their own intent and ability to hold securities as the critical determinant about whether a security is impaired and fair value losses must be recognized in income. In this study we propose that the intent and ability to hold criterion and partial fair value accounting system for investment securities can actually create incentives for banks to reduce securities sales, contrary to the pro-cyclical argument. We find evidence that banks sell less in securities when they face larger potential other-than-temporary impairment (OTTI) charges, such as during an economic downturn, but only for banks with Big 4 external auditors. These findings inform the standard-setting debate around accounting for securities at banks by documenting an economic reaction by banks to an accounting rule and the importance of the auditor in the application of that rule.

Authors

• Brett Wooten Cantrell, University of Mississippi

• Christopher G Yust, Texas A&M University