Fair Value Accounting for Financial Instruments: Does It Improve the Association Between Bank Leverage and Credit Risk?

Abstract

Many have argued that financial statements created under an accounting model that measures financial instruments at fair value would not fairly represent a bank’s business model. In this study we examine whether financial statements using fair values for financial instruments better describe banks’ credit risk than less fair-value-based financial statements. Specifically, we assess the extent to which various leverage ratios, which are calculated using financial instruments measured along a fair value continuum, are associated with various measures of credit risk. Our leverage ratios include financial instruments measured at 1) fair value; 2) US GAAP mixed-attribute values; and 3) Tier 1 regulatory capital values. The credit risk measures we consider are bond yield spreads and future bank failure. We find that leverage measured using the fair values of financial instruments explains significantly more variation in bond yield spreads and bank failure than the other less fair-value-based leverage ratios in both univariate and multivariate analyses. We also find that the fair value of loans and deposits appear to be the primary sources of incremental explanatory power.

Keywords: fair value accounting, credit risk, banking industry

JEL Classification: M41, G21, G24