Impact of fair-value accounting rules changes on financial institutions returns.
During the financial crisis of 2008-2009, there was extensive debate among policy makers, firms & academicians on the measurement and reporting of the fair value of assets and liabilities in the financial statements. The original FAS 157, which was adopted in September 2006, laid down the rules for measuring and reporting of fair values. This seems to work reasonably well when the market is stable and functioning smoothly, but problems arise during turbulent times such as financial crisis of 2008-2009. During such times, there are few if any buyers and companies are forced to use the distress price as the fair value which does not accurately reflect the underlying asset's true value. Many financial institutions had to write down the asset values, including mortgage-backed securities, and report significant losses. The losses were substantial enough to threaten the viability of some institutions.
Under pressure from the banking industry, the Congress, and the Federal Reserve, FASB changed the fair-value (mark-to-market) rule on April 9, 2009 by issuing FSP FAS 157-4, FSP No. FAS 115-2 and FAS 124-2 which gives flexibility to companies in determining fair value of assets and liabilities when the market is inactive and also allows banks to keep certain losses out of earnings. These changes in fair value accounting allow companies to use "significant" judgment when gauging the price of the assets, which may reduce banks' write downs.
The objective of this paper is to investigate the impact of the changes in fair-value accounting rule under FSP FAS 157-4, FAS 115-2 and FAS 124-2 on security prices of financial institutions. We focus on financial institutions only because they are most affected by these rulings. The banking industry has been lobbying for relaxation of the fair-value accounting rule ever since it was adopted under statement FAS157 in 2006.
There are a number of studies on the impact of fair value accounting on earnings, earnings volatility, contagion and stock prices (see, Barth et al (1995), Cornett et al (1996), Beatty et al (1996), and Plantin et al (2008)). These studies are for earlier periods and do not cover the financial crisis period of 2008-2009. In a more recent study, Bowen, R., U. Khan, and S. Rajgopal (2010) conduct a comprehensive analysis of the impact of FVA deliberations on stock prices. They examine ten event windows which include policymaker deliberations, recommendations and decisions about fair value accounting and impairment rules. They divide events into two groups: i) events that strongly suggested that FVA rules will be changed (deliberations, recommendations etc) and ii) events that suggested FVA rules will not be changed. They find positive stock price reactions for events that strongly suggest FVA rules will be changed and negative stock price reactions for events that suggest FVA rules will not be changed.
We examine the impact of the actual event of the issuance of revised fair value accounting rules (FSP FAS 157-4, FAS 115-2 and FAS 124-2) on April 9, 2009 on stock prices of financial institutions. Based on the finding of Bowen, Khan. and Rajgopal (2010), we expect to find a positive stock price reaction around the announcement date. This would also be consistent with the theory that investors would prefer to have more stable earnings reports from banks they invest in. Prior to the April 9, 2009 announcement, investors may have been concerned about the volatility of earnings and the ability of banks to meet their capital requirements due to asset write downs on assets that have temporarily illiquid markets.
PROVISIONS UNDER FSP FAS 157-4, FAS 115-2 and FAS 124-2
The original FAS 157 was adopted in September 2006. The main provisions of the original FAS 157 are as follows: fair value clearly defined, statement of sources of information used in fair value measurements (market or non-market based), and expanded disclosure requirements for assets & liabilities measured at fair value.
FAS-157, however, did not provide adequate guidance in how to value assets when the market is inactive, disorderly and illiquid. Under pressure from Congress, the SEC and Federal Reserve following the recent financial crisis, FASB issued FSP FAS157-4 on April 9, 2009. The statement lays down the rules for determining if the market is inactive and transactions disorderly, and for valuing assets that trade in these markets. Companies must determine if there has been a significant decrease in the volume and level of activity for assets under consideration. If there is a determination that there has been significant decrease in activity, indicating an inactive market, then they must look at the quoted prices or transactions but they are allowed to make significant adjustments to the values based on their judgment. The objective is to estimate the price of the asset that would prevail in an active and orderly market.
FSP No. FAS 115-2 and FAS 124-2 modified other-than-temporary impairment (OTTI) guidance in U.S. GAAP for debt securities. Under the proposed ruling, for securities the company intends to hold until maturity, they must separate the impairment in value in two categories: 1) the impairment in value because of deteriorated credit quality, and 2) the impairment because of other factors, such as distressed conditions in the market. The portion of value impairment attributed to credit quality must be recognized in earnings. The rest can be reported in an account in the balance sheet known as "other comprehensive account", which does not affect earnings and calculations of regulatory capital.
The financial crisis of 2008-2009 has generated a fierce debate about fair value accounting. Supporters argue that fair value accounting is the best way to go as it reflects the risk associated with the assets. Critics, on the other hand, argue that it is difficult to measure fair values of assets and, when markets are illiquid, it does not reflect the true value of the assets. Some critics even go as far as blaming the financial crisis of 2008-2009 on fair value accounting. Former FDIC Chairman, William Isaac, said:
"The devastation that followed stemmed largely from the tendency of accounting standards-setters and regulators to force banks, by means of their litigation-shy auditors, to mark their illiquid assets down to 'unrealistic fire-sale prices,'. The fair-value rules have destroyed hundreds of billions of dollars of capital in our financial system, causing lending capacity to be diminished by ten times that amount." (Katz, 2008).
Numerous news reports, articles, and analysis appeared in the media about fair value accounting during the financial crisis of 2008-2009. Barth, Landsman, and Wahlen .J.M. (1995) examine how fair value accounting affects earnings volatility and volatility of regulatory capital ratios. They report that fair value accounting increases volatility of earnings significantly, but has no impact on banks' cost of capital.
Cornett, Rezaee, and Tehranian (1996) investigate the stock price reaction of bank holding companies to the issuance of fair value accounting rules (SFAS 105, 107, and 115) in the early 1990s and find a negative impact on stock prices. Similarly, Beatty, Chamberlain, and Magliolo (1996) find a negative impact on stock prices of bank holding companies to the issuance of fair value accounting rules in the early 1990s.
Cifuentes, Ferrucci, and Shin (2005) show that fair value accounting has the potential for contagion among banks. Plantin, Shin, and Sapra (2008) show that FVA has the potential of spreading the market shocks, potentially leading to a breakdown of the entire banking system. Ian E. Scott (2009) examines whether or not fair value accounting rules played a significant role in the financial crisis and bank failures in the crisis of 2008-2009 and concludes that fair value accounting did not cause or contribute to the financial crisis.
Bowen, Kha, and Rajgopal (2010) conduct an event study of policymaker deliberations, recommendations and decisions about FVA and impairment rules in the banking industry. They find that events that signaled an increased probability that existing FVA standards would be relaxed generally produce a positive stock price reaction, while events that signaled FVA rules would not be relaxed have a negative stock price reaction.
The event examined in this investigation is the public announcement of revised Fair-Value Accounting Rules (FSP FAS 157-4, FAS 115-2 and FAS 124-2) by FASB. The event date is April 9 2009. The initial sample consists of 645 financial institutions. In order to be included in the sample, companies had to have returns in the CRSP database for the 255 day control period prior to the event period and for the 30 day event period. Our final sample includes 362 firms.
The authors of this study used event study methodology to model the stock price reactions of financial institution returns to the announcement of changes in the fair-value accounting rules. The statistical software EVENTUS was used to conduct the event study and calculate the test statistics. For each firm in the study, we run an ordinary least squares regression model over a 255 day period that ends 16 days before the announcement date. The only explanatory variable in the regression is the market return. Each day's individual stock return is the independent variable and the return on the market portfolio is the dependent variable. Each regression results in a beta for each firm during the estimation period. For the event period, we predict the daily returns for each stock based on the firm's regression beta and the return on the market portfolio. The following equation is used to calculate expected stock price returns:
[r.sub.jt] = [a.sub.j] + [bjr.sub.mt] + [e.sub.jt], (1)
[r.sub.jt] = the return on security j for period t,
[a.sub.j] = the intercept term,
[b.sub.j] = the covariance of the returns on the jth security with those of the market portfolio's returns,
[r.sub.mt] = the return on the CRSP equally-weighted market portfolio for period t, and
[e.sub.jt] = the residual error term on security j for period t.
The announcement date (day 0) is the date these rules were adopted by FASB. We calculate the expected return for each day in the event window (day -15 to day 15). The abnormal return ([ABR.sub.jt]) is the difference between the actual return and the expected return. It is calculated by subtracting the expected return (which uses the parameters of the firm from the estimation period and the actual market return for a particular date in the event period) from the actual return ([R.sub.jt]) on that date. The equation is as follows:
[ABR.sub.jt] = [R.sub.jt] - ([a.sub.j] + [b.sub.j][R.sub.mt]), (2)
where each of the parameters are as previously defined. The average abnormal return for a specific event date is the mean of all the individual firm abnormal returns for that date:
[MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII] (3)
where N is the number of firms used in calculation. The cumulative average abnormal return (CAAR) for each interval is calculated as follows:
[MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII] (4)
We also calculate the CAAR over multi-day event windows. Under the null hypothesis that there is no stock price reaction to the announcement of changes in fair-value accounting standards, the CAAR should be 0. The authors perform a Z-test to determine if the CAARs are significantly different from zero and use the Patell test, adjusted to account for serial correlation in the returns.
The findings are reported in Table 1. The cumulative average abnormal returns (CAARs) are positive and statistically significant for all event windows around the announcement date. The average abnormal return for the firms in the sample for the event window, 0, is 2.88 percent and is significant at the .0001 level. The average abnormal returns for event windows (-2, 0) and (0, 1) are 2.3 percent and 4.64 percent respectively, and are both significant at the .0001 level. The average abnormal returns for the event window (-2, 2) is 3.52 percent (significant at the .001 level).
The positive stock price reaction indicates that investors perceive this as a positive signal. As indicated before, financial institutions will benefit the most by the issuance of these pronouncements in terms of earnings and capital adequacy requirements.
This paper examines the stock price reaction of financial institutions to the issuance of revised fair value accounting rules on April 9, 2009. As expected, we report a significant positive price reaction. These rules allow banks to use judgment in estimating the fair value of assets when the market is inactive and also allows banks to keep certain losses out of earnings. This will improve their earnings and help in maintaining capital adequacy.
Investors view the announcement that FAS 157 is being relaxed as good news. Banks should have less volatility in their earnings, since they will have more flexibility in writing down asset values that trade in illiquid and distressed markets.
Barth, M.E., Landsman, W.R., & Wahlen .J.M. (1995). Fair value accounting: Effects on banks' earnings volatility, regulatory capital, and value of contractual cash flow. Journal of Banking and Finance, 19, 577-605.
Beatty, A., Chamberlain, S., & Magliolo .J. (1996). An empirical analysis of the economic implications of fair value accounting for investment securities. Journal of Accounting and Economics, 22, 43-77.
Bowen, R., Khan, U., & Rajgopal .S. ( 2010). The economic consequences of relaxing fair value accounting and impairment rules on banks during the financial crisis of 2008-2009. Working paper, University of Washington.
Cornett, M.M., Rezaee, Z,. & Tehranian. H. (1996). An investigation of capital market reactions to pronouncements on fair value accounting. Journal of Accounting and Economics, 22, 119-154.
Cifuentes, Ferrucci, & Shin (2005). Liquidity risk and contagion. Journal of the European Economic Association, 3, 2-3, 556-566.
Financial Accounting Standards Board (2007). SFAS No. 159: The fair value option for financial assets and financial liabilities.
Financial Accounting Standards Board (April 2009). FSP No. FAS 157-4: Determining fair value when the volume and level of activity for the asset or liability have significantly decreased and identifying transactions that are not orderly.
Financial Accounting Standards Board.(2009). FAS 115-2 and FAS 124-2: Recognition and Presentation of Other-Than-Temporary Impairments.
Katz, D.M. (October 29, 2008). Former FDIC chief: Fair value caused the crisis." http://www.cfo.com/article.cfm/12502908?f=members_110508
Plantin, G., Sapra .H. & Shin. H.S. ( 2008). Marking-to-market: Panacea or Pandora's box?" Journal of Accounting Research, 46: 435-460.
Scott, I.E. (2009). Fair Value Accounting Friend or Foe? Harvard Law School
Christopher L. Brown
Western Kentucky University
Christopher L. Brown has a PhD. in Finance from Oklahoma University and is currently the chair of Finance department at Western Kentucky University. He specializes in financial institutions, real estate and corporate finance.
Samanta Thapa earned his PhD. in finance from Georgia State University. He teaches Corporate and International Finance and has published in a number of prestigious journals.
Table 1 Cumulative Average Abnormal Returns Mean Generalized Event Window CAAR Patell Z Sign Z (-2, 0) 2.30% 4.866 *** 2.630 *** 0 2.88% 10.973 *** 4.838 *** (0, +1) 4.64% 11.436 *** 5.785 *** (-2, +2) 3.52% 3.146 ** 1.578 * *** Significant at the .0001 level. ** Significant at the .001 level. * Significant at the .1 level.
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|Author:||Brown, Christopher L.; Thapa, Samanta|
|Publication:||International Journal of Business, Accounting and Finance (IJBAF)|
|Date:||Mar 22, 2013|
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