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Why Banks Elected SFAS No. 159’s Fair Value Option: Opportunism versus Compliance with the Standard’s Intent

We examine the determinants of the timing of and financial instruments involved in banks’ initial fair value option (“FVO”) elections upon their adoption of SFAS No. 159. We focus on regular (in 2008:Q1) adopters of the standard, and distinguish their FVO elections from those of early (in 2007:Q1) adopters. Song (2008), Henry (2009), and Guthrie, Irving, and Sokolowsky (2009) find that early adopters’ elections exploited SFAS No. 159’s transition guidance to manage their accounting numbers. These studies provide essentially no evidence that either early or regular adopters complied with the standard’s intent that FVO elections remedy accounting mismatches for economically offsetting positions. In contrast, we hypothesize and provide evidence that regular adopters complied with that intent, having learned from guidance the SEC and others provided about that intent and from the scrutiny early adopters’ FVO elections received. Specifically, we predict and find that variables related to accounting mismatches explain regular adopters’ FVO elections but not early adopters’ elections. We predict and find that variables related to the management of accounting and regulatory capital numbers explain early adopters’ FVO elections but not regular adopters’ elections. We also examine banks’ initial FVO elections for the three most frequently elected types of financial instruments: AFS securities and debt for early adopters and loans held for sale for regular adopters. We provide four distinct economic and accounting reasons why banks’ FVO initial elections for AFS securities and debt were both amenable to exploitation of SFAS No. 159’s transition guidance and likely to create accounting mismatches, whereas banks’ initial FVO elections for loans held for sale were both not amenable to exploitation of the standard’s transition guidance and likely to remedy accounting mismatches. Based on these reasons, we predict and find that regular adopters’ FVO elections for loans held for sale remedied accounting mismatches and did not exploit SFAS No. 159’s transition guidance. We predict and find the opposite for early adopters’ FVO elections for AFS securities and debt. Our findings are consistent with regular adopters’ FVO elections, particularly for loans held for sale, complying with SFAS No. 159’s intent. Our findings are broadly consistent with Henry’s (2009) evidence that some early adopters rescinded or revised their FVO elections because of informal mechanisms that arose to help firms interpret and implement SFAS No. 159.