How Do Capital Rules Underestimate the Impact of Fair Value Accounting During the Crisis? An Examination of U.S. Global Systematically Important Banks

Abstract

Fair value accounting has been argued as one contributing factor to the recent global financial crisis occurred from 2007 to 2008. However, recent empirical studies find no significant evidence for this role of fair value accounting. One reason for this inconsistency comes from the weaknesses of the research methods applied by these studies. As large samples are investigated, it is natural that the evidence reflects the role of fair value accounting in small banks, and underweights the significance of systemically important banks. This paper examines the impact of accounting rules on the capital adequacy of six U.S. global systemically important banks (GSIBs) during the early period of the recent financial crisis. Indeed, this paper documents that when the leverage ratio and the Tier 1 capital ratio are used as the measure for capital adequacy, fair value accounting has contributed significantly to the deterioration of capital adequacy of two banks. Moreover, when the tangible common equity (TCE) ratio is used as the measure for capital adequacy, fair value accounting has a significant negative effect on all banks. Therefore, this paper argues that fair value accounting has played a significant role in the recent crisis as investors focused on the TCE as the actual capital which absorbed losses.