Accounting standard-induced regulatory capital management : evidence from the new lease accounting standard ASC 842

Abstract

The new lease accounting standard, ASC 842, exerts a downward pressure on the regulatory capital ratio of U.S. banks due to the requirement to fully risk-weight capitalized operating lease assets for regulatory capital purposes. To mitigate regulatory risk associated with breaching or getting close to the regulatory minimum, banks may exercise discretion in adjusting their balance sheets, ex-post. Such a discretion may not align with regulators’ expectations given the potential real economic implications. In this study, we examine whether and how U.S. banks manage their balance sheets to mitigate the potential adverse impact of ASC 842 on their regulatory capital ratios. Using a difference-in-differences design around the effective date of ASC 842, we find that ex-ante less capitalized banks shore up their Tier 1 capital ratio higher upon adoption of ASC 842, relative to better-capitalized banks, achieved primarily through a reduction in lending growth rather than an increase in shareholders’ equity (ordinary share capital and retained earnings). Further results suggest that the cut in lending growth is accounted for by a reduction in the growth rates of real estate loans and loans to individuals, in line with banks shrinking their assets in compliance with the new rule. In the cross-section, the results (increase in Tier 1 ratio growth and decline in lending growth) are particularly pronounced among banks with higher levels of ex-ante operating lease commitments, consistent with a lease-induced regulatory capital management. Moreover, the results are stronger in banks that are riskier and those that pay higher dividends, ex-ante, but muted for advanced approaches banks relative to non-advanced approaches banks. Overall, the evidence in this study suggests that banks reveal prefer shrinking credit growth to raising equity levels in response to the new lease accounting standard, highlighting a potential unintended consequence of operating lease capitalization.