Bank Risk and the Value Relevance of Fair Value Gains and Losses

• Main Authors: LIM, Chu Yeong, Walker, Martin, LEE, Edward, Kausar, Asad
• Format: text
• Language: English
• Published: Institutional Knowledge at Singapore Management University 2011
• Subjects: Accounting; Finance and Financial Management
• Online Access: https://ink.library.smu.edu.sg/soa_research/908
• Institution: Singapore Management University

This paper studies the value relevance of fair value gains and losses for an international sample of banks. We investigate if the value relevance of fair value gains and losses increases or decreases with bank risk. One possibility is that, as risk increases, the scope for subjectivity in fair value estimates increases thereby potentially rendering the numbers less useful. However another possibility is that the relevance of faithfully reported fair values increases as risk increases. We ask which of the two opposing forces is greatest. Using hand collected data we construct a model of bank returns based on the most important components of a bank’s net income. We disaggregate net income into profits before taxes, loan loss provisions, fair value gains and losses, and other operating income. We also distinguish between the operating profits and loss provisions of retail and corporate banking lines of business. The main finding is that the value relevance of fair value gains and losses is positively related to the level of bank risk prior to the crisis. During the crisis there is also evidence of a similar positive relationship, but it is not possible to draw firm conclusions for reasons we discuss. As a complement to the main result we find that the fair value gains/losses of banks that elect to use the fair value option for assets that could have been accounted for in terms of amortized costs are more value relevant and persistent. From a policy viewpoint our results suggest that, since fair value gains and losses of banks are especially informative for risky banks, such gains and losses should be separately accounted for according to line of business.