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

55 Pages Posted: 7 Mar 2010 Last revised: 2 Feb 2015

Elizabeth Blankespoor

Stanford University - Graduate School of Business

Thomas J. Linsmeier

Financial Accounting Standards Board

Kathy R. Petroni

Michigan State University - Eli Broad College of Business and Eli Broad Graduate School of Management

Catherine Shakespeare

University of Michigan - Stephen M. Ross School of Business

Date Written: November 1, 2012

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

Suggested Citation

Blankespoor, Elizabeth and Linsmeier, Thomas J. and Petroni, Kathy R. and Shakespeare, Catherine, Fair Value Accounting for Financial Instruments: Does It Improve the Association Between Bank Leverage and Credit Risk? (November 1, 2012). The Accounting Review, Vol. 88, No. 4, pp. 1143-1177; Rock Center for Corporate Governance at Stanford University Working Paper No. 121; Stanford University Graduate School of Business Research Paper No. 2107. Available at SSRN: https://ssrn.com/abstract=1565653 or http://dx.doi.org/10.2139/ssrn.1565653

Elizabeth Blankespoor

Stanford University - Graduate School of Business ( email )

655 Knight Way
Stanford, CA 94305-5015
United States

Thomas J. Linsmeier

Financial Accounting Standards Board ( email )

401 Merritt 7
P.O. Box 5116
Norwalk, CT 06856-5116
United States
203-956-5208 (Phone)
203-847-6030 (Fax)

Kathy Ruby Petroni (Contact Author)

Michigan State University - Eli Broad College of Business and Eli Broad Graduate School of Management ( email )

East Lansing, MI 48824-1121
United States
517-432-2924 (Phone)
517-432-1101 (Fax)

Catherine Shakespeare

University of Michigan - Stephen M. Ross School of Business ( email )

701 Tappan Street
Ann Arbor, MI MI 48109
United States

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