52Fair value accounting Effects on banks earnings

JournalofBANKING&ELSEVIERFINANCEJournalofBanking&Finance19(1995)577-605Fairvalueaccounting:Effectsonbanks'earningsvolatility,regulatorycapital,andvalueofcontractualcashflowsMaryE.Bartha,*,WayneR.Landsmanb,JamesM.WahlenbaHarvardBusinessSchool,Morgan417,Boston,MA02163,USAbKenan-FlaglerBusinessSchool,CarrollHall-CB3490,UnioersityofNorthCarolina,ChapelHill,NC27599-3490,USAAbstractWeinvestigatefairvalueaccountingcritics'assertionsbyrestatingearningsandregulatorycapitaltoreflectbanks'disclosedinvestmentsecuritiesfairvalues.Wefind:(1)Fairvalue-basedearningsaremorevolatilethanhistoricalcostearnings,butsharepricesdonotreflecttheincrementalvolatility.(2)Banksviolateregulatorycapitalrequirementsmorefrequentlyunderunderfairvaluethanhistoricalcostaccounting.Fairvalue-basedviolationshelppredictregulatorycapitalviolations,butsharepricesdonotreflectthispotentialincreasedregulatoryrisk.Onlyhistoricalcostviolationsaremarketinformationevents.(3)Sharepricesreflectinterestrateschanges,eventhoughinvestmentsecurities'contractualcashflowsare.fixed.Keywords:Banks;Investmentsecurities;Fairvalueaccounting;Regulatorycapital;Earnings;CashflowsJELclassification:M41;G21;G281.IntroductionThe1980switnessedthegreatestnumberoffinancialinstitutionfailuresinU.S.history.Thesavingsandloancrisisandwidespreadconcernovertheviabilityof*Correspondingauthor.Phone:[phone]-4266/95/$09.50©1995ElsevierScienceB.V.AllrightsreservedSSDI0378-4266(94)00141-3578M.E.Barthetal./JournalofBanking&Finance19(1995)577-605theU.S.bankingsystemcausedmanytoquestiontheusefulnessofhistoricalcostaccountingbecause,expost,itappearsthatmanyfailedinstitutionshadnegativeeconomicnetworth,eventhoughbasedonhistoricalcostaccountingtheyreportedpositivenetworthinexcessofregulatoryrequirements.Historicalcostaccountingdidnotcausefinancialinstitutionstofail.However,manybelievethatfairvalueaccountingwouldhaveledregulatorsandotherfinancialstatementuserstoaddresstheinstitutions'financialdifficultiesearlier,andthusgreatlyreducethecosttotaxpayersofresolvingtheresultingcrisis.1Theyalsoadvocateusingfairvalueaccounting,assertingthatitbetterreflectsunderlyingeconomicvalues.Underfairvalueaccounting,changesinfairvalues,i.e.,unrealizedholdinggainsandlosses,arerecognizedincurrentearnings.Incontrast,underhistoricalcostaccounting,changesinvaluetypicallyarenotrecognizeduntilrealized.Eventhoughthefairvalueaccountingdebaterelatestoallentitiesandallassetsandliabilities,thefocushasbeenbanks'investmentsecurities.2InMay1993,theFinancialAccountingStandardsBoard(FASB,1993)issuedStatementofFinan-cialAccountingStandards(SFAS)No.115,'AccountingforCertainInvestmentsin.DebtandEquitySecurities.'Oneintendedeffectofthestandardistorecognizeatfairvaluemoresecuritiesinvestmentsthaniscurrentlythecase.3Underprioraccountingrules,mostbanks'securitiesinvestmentswererecognizedathistoricalcost,andestimatesoftheirfairvaluesweredisclosed.Althoughdisclosureandrecognitionshouldbeinformationallyequivalent,bankmanagersandothersappeartobelievetheyarenot.Moreover,totheextentthatrecognizedamountsareusedtodetermineregulatorycapital,changesinrecognitionrulesdirectlyaffectbanks'economiccondition.AlthoughSFAS115appliestoallentities,bankmanagersareamongitsmostoutspokencriticsbecauseinvestmentsecuritiescompriseasubstantialportionofbanks'totalassets.BecausefairvaluesreflectgeneralmarketconditionsinlSeeBeaveretal.(1992)forfurtherdiscussion.2Thedebateconcerningwhethercurrentvaluemeasuresaremorerelevantthanhistoricalcostsisnotnewtotheaccountingprofession.Forexample,SFAS33oncurrentandreplacementcostsandSFAS19onoilandgasrequireddisclosureofcurrentvalueestimates.Priorresearchexaminingdisclosuresprovidedunderthesestandardscastsdoubtonthevalue-relevanceofcurrentcostestimatesincrementaltohistoricalnumbers,atleastforphysicalassets.See,e.g.,BeaverandLandsman(1983),BernardandRuland(1987)(SFAS33),andHarrisandorison(1987)andMagliolo(1986)(SFAS19).3Banksclassifytheirinvestmentsindebtsecuritiesintothreecategories:(1)Investmentsecuritiesrecognizedathistoricalcostnetofanyunamortizedpremiumordiscount,(2)tradingsecuritiesrecognizedatfairvalue,and(3)securitiesheldforsalerecognizedatthelowerofcostormarket.Securitiesotherthaninvestmentsecuritiestypicallycompriseasmallfractionoftotalassets.Theterms'marketvalue,''fairvalue,''mark-to-market,'and'marketvalue-based'accountingoftenareusedinterchangeably.InSFAS107,theFASB(1991)adoptstheterm'fairvalue'becausenotallassetsorliabilitiesaretradedinactivemarkets,includingbanks'investmentsecurities.Inthisstudy,unlessstatedotherwise,theterm'fairvaluenetincome'or'earnings'referstonetincomeadjustedforunrealizedsecuritiesgainsandlosses.M.E.Barthetal./JournalofBanking&Finance19(1995)577-605579additiontoconditionsspecifictoaparticularinstitution,manybankmanagersexpressconcernthatfinancialstatementusers-notablyinvestorsandregulators-willbemisledbyfairvalueaccounting.DuringtheFASB'spublichearings,represen-tativesfromtheAmericanBankersAssociation,theIndependentBankersAssocia-tionofAmerica,andauditfirmswithbankclients,amongothe