Does Fair Value Accounting Exacerbate the Pro-cyclicality of Bank Lending?

This paper examines whether fair value accounting increases the pro-cyclicality of banks’ lending behavior. Exploiting cross-sectional variation in individual banks’ exposure to fair value accounting, I find that fair value accounting does not exacerbate the pro-cyclicality of bank lending over the past two business cycles during 1995-2010. This result holds despite the fact that every one dollar of unrealized gains (losses) is associated with at least 25 cents of new lending (cutbacks in lending). The probable cause of this non-exacerbation finding is that interest rates rise (fall) during some of the expansionary (recessionary) periods, resulting in movements of bank assets’ fair value that are not pro-cyclical. I would like to express my deepest gratitude to my dissertation chair, K.R. Subramanyam, for his continuous guidance and insightful suggestions in the development of this paper. I am also thankful to my other committee members Mark DeFond and, especially, Jieying Zhang for their comments and support. This paper benefited from helpful comments from Elizabeth Chuk, Wayne Ferson, Jessica Halenda, Ayse Imrohoroglu, Yihong Jiang, Yuri Loktionov, Kevin Murphy, Mingyi Hung, Siqi Li, David Maber, Jeff McMullin, Suresh Nallareddy, Bryce Schonberger, Karen Ton, Robert Tresevant, Selale Tuzel, Alicia Yancy, and workshop participants at University of Southern California. The Dissertation Completion Fellowship from USC Graduate School is gratefully acknowledged. All errors are my own. E-mail correspondence to [email protected]. 1 Does Fair Value Accounting Exacerbate the Pro-cyclicality of Bank Lending? “The second problem involves ways of making the system less pro-cyclical so that the financial system is less susceptible to exuberant booms and disastrous busts.... Capital rules, accounting policies, and other regulatory standards should not make this job even more difficult by encouraging excessively pro-cyclical behavior by financial institutions, that is, behavior that causes financial institutions to tighten credit in downturns and ease credit in booms more than is justified by changes in the credit worthiness of borrowers.” Ben Bernanke, March 20, 2009