The Contribution of Bank Regulation and Fair Value Accounting to Procyclical Leverage

Our analytical description of how banks’ responses to asset price changes can result in procyclical leverage reveals that for banks with a binding regulatory leverage constraint, absent differences in regulatory risk weights across assets, procyclical leverage does not occur. For banks without a binding constraint, fair value and bank regulation both can contribute to procyclical leverage. Empirical findings based on a large sample of US commercial banks reveal that bank regulation explains procyclical leverage for banks relatively close to the regulatory leverage constraint and contributes to procyclical leverage for those that are not. We also show that fair value accounting does not contribute to procyclical leverage by finding (i) the portion of comprehensive income attributable to fair value accounting, i.e., fair value comprehensive income, has a negative relation with change in leverage as expected for any increase in equity, (ii) no evidence of a positive relation between fair value comprehensive income and banks’ net purchases of assets, and (iii) the relation between change in leverage and fair value comprehensive income is more negative than that between change in leverage and change in equity.