Banks' Asset Reporting Frequency and Capital Regulation: An Analysis of Discretionary Use of Fair-Value Accounting

This paper examines banks' choice between fair-value and historical-cost accounting when reported accounting information is used in capital requirement regulation. We center our analysis on a key difference between fair-value and historical-cost accounting: the frequency with which asset value changes are reported. We show that the elasticity of banks' loan returns to aggregate lending is a critical determinant of the interaction between capital adequacy requirements and accounting choices. If lending returns are inelastic, higher capital requirements reduce fair-value usage. By contrast, higher capital requirements encourage fair-value if capital requirements are low and lending returns are sufficiently elastic. In equilibrium, banks may elect different accounting choices and we find that mandating uniform adoption of historical-cost (fair-value) is desirable when capital requirements are loose (tight). Our study offers many other implications about fundamental links between accounting and prudential cho...