An Examination of Other‐than‐temporary Impairments: Evidence from FSP FAS 115‐2 and FAS 124‐2

Abstract

This study investigates amendments to the other‐than‐temporary impairment (OTTI) measurement and recognition guidance for debt securities in the Financial Accounting Standards Board's Staff Position FAS 115‐2 and FAS 124‐2 (‘the FSP’). The FSP permits the OTTI charge for debt securities to be split into the credit loss amount recognized in net income (NI) and the amount related to all other factors (noncredit loss) recognized in other comprehensive income (OCI) under certain instances. Thus, the FSP provides banks with additional discretion in recognizing the amount of unrealized losses in NI. Using quarterly accounting data on US bank holding companies from the first quarter of 2010 to the fourth quarter of 2016, I examine whether banks’ decisions regarding OTTI bifurcation are associated with financial reporting and regulatory capital incentives. First, I predict and find that proxies for regulatory capital management, income smoothing, and big bath behaviour impact the percentage of OTTI recognized in OCI. Further evidence suggests that banks with histories of income smoothing through loan loss provision and realized security gains and losses assign a greater share of OTTI to OCI. Then, I predict and find that banks manage OTTI recognized in NI downward to meet quarterly financial reporting benchmarks. Finally, I show that banks with a higher discretionary proportion of OTTI recognized in OCI increase their lending over the subsequent quarter.