Procyclical Leverage: Bank Regulation or Fair Value Accounting?

We analyse how banks’ responses to asset gains and losses can result in procyclical leverage. The analysis reveals that absent differences in regulatory risk weights across assets, leverage is not procyclical. We test predictions from the analysis using a sample of US commercial banks and find that the procyclical relation between leverage changes and asset changes evaporates in the presence of regulatory risk weight changes. Also, all equity changes are negatively related to leverage changes, which is inconsistent with fair value accounting contributing to procyclical leverage. We conclude that risk-based regulatory requirements explain banks’ procyclical leverage, not fair value accounting.

This seminar is organised by the Erasmus Accounting Research Group.