Does Fair Value Accounting Contribute to Procyclical Leverage?

We describe analytically commercial bank behavior focusing on actions banks take in response to economic gains and losses on their assets to meet regulatory leverage requirements. Our analysis shows that absent differences in regulatory risk weights across assets, leverage cannot be procyclical. We test the analytical description's predictions using a sample of US commercial banks, during economic upturns and downturns, including the recent financial crisis. Although we find a significantly positive relation between change in leverage and change in assets, this procyclical relation evaporates when change in each bank's weighted average regulatory risk weight is included in the estimating equation. We also find that all changes in equity, including those arising from fair value accounting, are significantly negatively related to change in leverage, which is inconsistent with fair value accounting contributing to procyclical leverage. In addition, we find no evidence of a relation between change in leverage and the interaction between change in assets arising from fair value accounting and other changes in assets. Taken together, the empirical evidence indicates that fair value accounting is not a source of procyclical leverage. The key conclusion we draw is that bank regulatory requirements, particularly regulatory leverage determined using regulatory risk-weighted assets, explain why banks' leverage can be procyclical, and that fair value accounting does not.