Fair Value Accounting: Effects on Banks’ Earnings Volatility, Regulatory Capital, and Value of Contractual Cash Flows

We investigate fair value accounting critics’ assertions by restating earnings and regulatory capital to reflect banks’ disclosed investment securities fair values. We find: (1) Fair value-based earnings are more volatile than historical cost earnings, but share prices do not reflect the incremental volatility. (2) Banks violate regulatory capital requirements more frequently under under fair value than historical cost accounting. Fair value-based violations help predict regulatory capital violations, but share prices do not reflect this potential increased regulatory risk. Only historical cost violations are market information events. (3) Share prices reflect interest rates changes, even though investment securities’ contractual cash flows are fixed.