The effect of the fair value option on bank earnings and regulatory capital management: Evidence from realized securities gains and losses

Abstract

Prior research shows that banks achieve reporting objectives using realized securities gains/losses on sales of available-for-sale securities (AFS). Building on this, I investigate whether earnings and regulatory capital management incentives differ between fair value option (FVO) banks and non-FVO banks. FVO banks are allowed to report unrealized gains/losses on elected AFS securities in both current earnings and regulatory capital, whereas, to receive this treatment, non-FVO adopters must sell AFS securities. Using a balanced panel sample covering pre- and post-FVO implementation periods, I find evidence that banks with net positive FVO earnings have fewer earnings and regulatory capital management incentives than do non-FVO banks. My study is of interest to standard setters seeking to reduce earnings and regulatory management behavior, and investors and researchers assessing the implications of the FVO on managers' discretionary actions.