Regulatory Treatment of Changes in Fair Value and the Composition of Banks' Investment Portfolios

In the wake of the financial crisis of 2007-2008, Basel III recommended that bank regulators include changes in the fair value of available-for-sale (AFS) debt securities in Tier 1 capital. However, the U.S. implementation allowed smaller banks to continue excluding these changes through a one-time opt out election. This paper investigates a potential impact of this opt out provision by examining the investment decisions of smaller banks in the 1990's when changes in the fair value of AFS debt securities were temporarily included in regulatory capital. Using a sample of smaller banks and a difference-in-differences research design, we find that low-capitalized banks reduced their investments in more volatile asset classes (e.g., corporate bonds, non-agency MBS) and increased their investments in less volatile asset classes (e.g., treasuries and municipal bonds) after changes in fair value were included in regulatory capital. These findings suggest that providing smaller banks with an opt out election potentially allows low-capitalized, riskier banks to continue to hold more volatile securities in their AFS portfolios.