Real Regulatory Capital Management and Dividend Payout: Evidence from Available-for-Sale Securities

The 2007–2009 financial crisis has re-ignited a long-running debate about the relative merits of historical cost accounting (HCA) or fair value accounting as foundations for prudential oversight, including the calculation of regulatory capital. Available-for-sale securities provide a good setting to further explore this issue. Using a sample of 5,333 firm-year observations representing 721 unique U.S. banks and bank holding companies between 1998 and 2013, we present evidence that regulatory capital based on HCA induces banks to engage in gains trading activities to improve their capital position and pay dividends. We also document that banks experiencing a decrease in regulatory capital and banks with a higher percentage of institutional investors are more prone to engage in gains trading to pay dividends. Finally, our findings reveal that to counterbalance the increased risk, banks change their lending behavior and decrease the riskiness of their trading portfolios. Overall, our results reveal the potential side effects linked to the use of HCA as a foundation to compute regulatory capital and suggest that HCA is not a panacea.
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