Banks’ Discretion over the Debt Valuation Adjustment for Own Credit Risk

Posted: 21 Feb 2017 Last revised: 4 Feb 2019

See all articles by Minyue Dong

Minyue Dong

University of Lausanne - Faculty of Business and Economics (HEC Lausanne)

Leonidas C. Doukakis

University of Lausanne, HEC

Stephen G. Ryan

New York University (NYU) - Leonard N. Stern School of Business

Date Written: January 31, 2019

Abstract

Prior to 2018, accounting rules required banks that recognize financial liabilities at fair value to record unrealized gains and losses on the liabilities attributable to changes in the banks’ own credit risk, referred to as the debt valuation adjustment (DVA), in earnings each period. Using a comprehensive sample of publicly traded European banks during 2007–2015, we investigate the economic determinants of DVA and banks’ exercise of discretion over DVA. We find that DVA exhibits the expected associations with economic factors, e.g., is positively associated with the change in banks’ bond yield spread. We decompose DVA into normal and abnormal components and find that abnormal DVA is negatively associated with pre-managed earnings, controlling for banks’ abnormal loan loss provisions and realized securities gains and losses, consistent with banks exercising discretion over DVA to smooth earnings. We further find that banks that record larger loan loss provisions or realized gains and losses and banks that have histories of using provisions or realized gains and losses to smooth earnings are less likely to exercise discretion over DVA to smooth earnings. These findings generally are consistent with banks using loan loss provisions, realized gains and losses, and DVA substitutably to smooth earnings. Lastly, we provide evidence that banks exercised discretion over DVA to smooth earnings during the recent financial crisis but not afterward. These findings have implications for how bank regulators and investors should interpret banks’ reported DVA, and they support the decisions by the IASB and FASB to require firms to record DVA in other comprehensive income starting in 2018.

Keywords: Debt valuation adjustment; DVA; Own credit risk; Fair value option for liabilities; Income smoothing

JEL Classification: G18, G21, G28, K23, M41, M48

Suggested Citation

Dong, Minyue and Doukakis, Leonidas C. and Ryan, Stephen G., Banks’ Discretion over the Debt Valuation Adjustment for Own Credit Risk (January 31, 2019). Available at SSRN: https://ssrn.com/abstract=2920617 or http://dx.doi.org/10.2139/ssrn.2920617

Minyue Dong (Contact Author)

University of Lausanne - Faculty of Business and Economics (HEC Lausanne) ( email )

Building Antropole 3022, HEC
Mail box No. 38
Lausanne-Dorigny, Vaud. 1015
Switzerland
(41) 21 6923367 (Phone)
(41) 21 6923305 (Fax)

Leonidas C. Doukakis

University of Lausanne, HEC ( email )

Unil Chamberonne, Batiment Anthropole
Lausanne, 1015
Switzerland

Stephen G. Ryan

New York University (NYU) - Leonard N. Stern School of Business ( email )

44 West 4th Street, Suite 10-73
New York, NY 10012-1118
United States
212-998-0020 (Phone)

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