Does Fair Value Accounting Exacerbate the Procyclicality of Bank Lending?

• DOI: http://doi.org/10.1111/1475-679X.12103
• Date: 01 March 2016
• Published date: 01 March 2016
• Author: BIQIN XIE

DOI: 10.1111/1475-679X.12103

Journal of Accounting Research

Vol. 54 No. 1 March 2016

Printed in U.S.A.

Does Fair Value Accounting

Exacerbate the Procyclicality

of Bank Lending?

BIQIN XIE

∗

Received 8 November 2012; accepted 19 October 2015

ABSTRACT

This study investigates whether fair value accounting contributes to the pro-

cyclicality of bank lending. Using banks’ approval/denial decisions on resi-

dential mortgage applications to capture banks’ supply of credit, I find no

evidence that fair value accounting has procyclical effects on bank lending

over the past two business cycles. I further identify two reasons for this re-

sult. First, the main accounting item distinguishing fair value accounting

from historical cost accounting—unrealized gains and losses on available-for-

sale securities—does not affect lending decisions. Second, unrealized gains

and losses on available-for-sale securities are not procyclical, as the risk-free

∗Pennsylvania State University.

Accepted by Christian Leuz. I am especially grateful to an anonymous reviewer for in-

sightful suggestions. This article is based on my dissertation at the University of Southern

California. I would like to express my deepest gratitude to my dissertation chair, K.R. Subra-

manyam, for his continuous guidance and insightful suggestions in the development of this

article. I am thankful to my other committee members, Mark DeFond, Jeffrey Nugent, and

especially Jieying Zhang, for their comments. This article benefited from helpful comments

from Orie Barron, Randy Beatty, Elizabeth Chuk, Kai Du, Wayne Ferson, Guojin Gong, Jes-

sica Halenda, Rebecca Hann, Steve Huddart, Mingyi Hung, Ayse Imrohoroglu, Yihong Jiang,

Siqi Li, Henock Louis, Yuri Loktionov, David Maber, Jeff McMullin, Kevin Murphy, Suresh

Nallareddy, Hong Qu, Bryce Schonberger, Karen Ton, Robert Trezevant, Selale Tuzel, and

Alicia Yancy, as well as from workshop participants at the University of Southern Califor-

nia, Pennsylvania State University, Arizona State University, Florida International University,

and George Mason University. The Dissertation Completion Fellowship from USC Graduate

School is gratefully acknowledged. An Online Appendix to this article can be downloaded at

http://research.chicagobooth.edu/arc/journal-of-accounting-research/online-supplements.

235

Copyright C, University of Chicago on behalf of the Accounting Research Center,2015

236 B.XIE

interest rate rises during some expansionary periods, resulting in unrealized

losses, while the risk-free interest rate (and sometimes the default spread)

falls during some recessionary periods, resulting in unrealized gains.

JEL codes: E32; G21; M41

Keywords: bank lending; fair value accounting; procyclicality

1. Introduction

This study examines whether fair value accounting exacerbates the pro-

cyclicality of bank lending, that is, the tendency of banks to expand credit

in economic upturns and curtail credit in downturns. Critics argue that, in

economic upturns, fair value accounting leads to asset write-ups that enable

banks to originate more loans, while, in downturns, fair value accounting

leads to write-downs that force banks to cut back on lending. In line with

this view, at the height of the recent financial crisis 65 members of Congress

wrote to the Securities and Exchange Commission (SEC) that “the ‘mark-

to-market’ rule, while well intended, has the unintended consequences of

exacerbating economic downturns by hamstringing the ability of banks to

make loans to consumers and businesses” (U.S. Congress [2008]). The Eu-

ropean Central Bank [2004] and the International Monetary Fund [2008]

have also expressed concerns that fair value accounting can increase lend-

ing procyclicality.1Questioning the validity of these claims and the role

of fair value accounting in the crisis on both conceptual and empirical

grounds, Laux and Leuz [2009, 2010] call for more research on this topic,

as some of the evidence they refer to is anecdotal in nature. This article

answers the call for research by examining whether fair value accounting

contributes to more aggressive lending during economic expansions and

to reduced lending during recessions.

Understanding the link between fair value accounting (on securities)

and bank lending is important for three reasons. First, lending is bank hold-

ing companies’ most important activity, and credit availability is essential to

the functioning and growth of the economy. Second, bank holding com-

panies typically have high leverage relative to nonfinancial firms, and thus

even small losses (including small losses on securities) can have a major

effect on banks’ lending capacity and in turn on credit availability. Third,

understanding the relation between fair value accounting and bank lend-

ing can help us better understand the real effects of fair value accounting,

which should better inform policy decisions.

It is unclear ex ante whether fair value accounting should have procycli-

cal effects on lending. Loans are recorded at historical cost rather than

1The International Monetary Fund [2008, p. 123], for example, cautions that, under fair

value accounting, “Exaggerated profits in good times create the wrong incentives. Conversely,

more uncertainty surrounding valuation in downturns may translate into overly tight credit

conditions, and negatively affect growth at a time when credit expansion is most needed.”

FAIR VALUE ACCOUNTING AND LENDING PROCYCLICALITY 237

fair value. Although trading assets and available-for-sale (AFS) securities are

the two major types of bank assets measured at fair value, unrealized gains

and losses on trading assets are likely immaterial as trading assets gener-

ally are actively traded for short-term profit and typically held in significant

amounts only by very large banks.2Thus, unrealized gains and losses on

AFS securities mainly distinguish fair value accounting from historical cost

accounting. Given that fair value accounting does not pertain to loans, in

order for fair value accounting to have procyclical effects on lending, there

must be a spillover from the accounting for AFS securities to lending; that

is, unrealized AFS gains (losses) must (a) induce banks to increase (reduce)

lending, and (b) arise mainly during economic expansions (recessions).

Whether bank lending is sensitive to unrealized AFS gains and losses is

unclear. Unrealized AFS gains and losses generally do not affect banks’ reg-

ulatory capital and hence are less likely to affect their lending capacity,

since banks’ lending capacity is typically a function of their regulatory cap-

ital.3Regulatory rules and actions, however, suggest that bank regulators

may consider unrealized AFS gains and losses in evaluating the adequacy

of a bank’s regulatory capital (e.g., Office of the Comptroller of the Cur-

rency [1994, 2013]). Thus, unrealized AFS gains and losses can potentially

change a bank’s likelihood of violating regulatory capital requirements and

therefore affect its lending capacity, or lead a bank to deviate from its target

regulatory capital ratios and thereby induce it to return to its target ratios

by adjusting lending.4

But even if unrealized AFS gains and losses affect banks’ regulatory cap-

ital (or expectations for it), it is not clear whether unrealized AFS gains

(losses) arise mainly during economic expansions (recessions), that is,

whether or not unrealized AFS gains and losses are procyclical. AFS securi-

ties are primarily debt securities with relatively low credit risk (e.g., agency

mortgage-backed securities, Treasury bonds, and municipal bonds), and

hence their fair values decline (rise) as a result of increases (decreases) in

the risk-free interest rate, holding term and default spreads constant. The

risk-free rate typically rises in economic expansions and falls in recessions,

which can give rise to unrealized AFS losses during expansions and unreal-

ized AFS gains in recessions.

To examine whether fair value accounting contributes to the procycli-

cality in banks’ supply of credit, I measure banks’ lending behavior us-

ing their approval/denial decisions on residential mortgage applications.

2For convenience, this paper uses the terms “bank holding companies” and “banks” inter-

changeably.

3Bank holding companies must maintain capital ratios at levels above a regulatory

minimum. The rules for determining a bank holding company’s capital adequacy are

provided in Appendix A to CFR Part 225 (Regulation Y), available at http://www.gpo.

gov/fdsys/pkg/CFR-2012-title12-vol3/pdf/CFR-2012-title12-vol3-part225-appA.pdf.

4Adrian and Shin [2011] find that banks’ equity is sticky, which suggests that banks achieve

their target regulatory capital ratios mainly by adjusting the size of their assets and liabilities

instead of equity.