JOURNAL OF Accounting &Economids

ELSEVIER Journal of Accounting and Economics 22 (1996) 79 117

Fair value disclosures by bank holding companies Elizabeth A. Eccher a, K. R a m e s h *'b, S. R a m u Th iaga ra j an ~

a Sloan School of Management, Massachusetts Institute of Technology, Cambridge, MA 02142, USA b William E. Simon Graduate School of Business Administration, University of Rochester. R~chester.

NY 14627, USA C J.L. Kellogg Graduate School o f Management, Northwestern University', Evanston, IL 60208, USA

(Received May 1995; final version received August 1996)

Abstract

This paper examines the value relevance of fair value data disclosed under SFAS 107 by banks for 1992 and 1993. Collectively, the evidence suggests differences between fair and book values of financial instruments are associated with market- to-book ratios. However, fair value disclosures for financial instruments other than securities are value- relevant only in limited settings. In addition, only in 1992 are fair value variables associated with market- to-book ratios after incorporating existing historical cost in- formation. Further analysis suggests the weaker 1993 results are not necessarily due to increased measurement error in fair value numbers.

K e y words: Market value accounting; Bank holding companies; Fair value disclosures: Off-balance-sheet instruments

J E L classification: G21; M41; C21

* Corresponding author.

We are very grateful for the comments and suggestions provided by an anonymous referee, Tom Lys (the discussant), and especially Ross Watts (the editor). We acknowledge valuable inputs from Eli Amir, Joe Anthony, Linda Bamber, Mary Barth, Dorsey L. Baskin, Jr., Bill Beaver, Carl Beidleman, George Benston, Tom Carroll, Dan Collins, Eugene Comiskey, Dan Givoly, Stuart Greenbaum, Trevor Harris, Carla Hayn, Bruce Johnson, Jim Johnson, Todd Johnson, S.P. Kothari, Greg Krippel, Tom Linsmeier, Jim Ohlson, Jamie Pratt, Tom Prince, John Stewart, Tom Stober, Bob Swieringa, Jake Thomas, Rick Tubbs, Terry Warfield, John Wild, Pete Wilson, the seminar participants at the University of California at Berkeley, Emory University, Indiana University, Columbia University, the University of Iowa, the 1993 AAA-FASB Conference on Financial Reporting, the participants at the 1994 American Accounting Association Annual Meetings, especially the discussant Susan Rifle, and the participants at the 1995 JAE conference. We acknowledge the expert research assistance provided by Jonathon Singer. The research support provided by the Accounting Research Center and the Bank- ing Research Center of the J.L. Kellogg Graduate School of Management is gratefully acknowledged.

0165-4101/96/$15.00 (~ 1996 Elsevier Science B.V. All rights reserved PII S0 1 65 -4 1 01 ( 9 6 ) 0 0 4 3 8 - 7

80 E.A. Eccher et al. / Journal of Accounting and Economics 22 (1996) 79 117

1. Introduction

We analyze the value relevance of fair value data disclosed by about 300 bank holding companies under the requirements of Statement of Financial Ac- counting Standards No. 107 (SFAS 107). We define value relevance in terms of the association of supplementary fair value disclosures with share prices. The central research question examined here is whether fair value disclosures man- dated by SFAS 107 have incremental association with market value over and above information disclosed in banks' financial statements prior to SFAS 107.1

Advocates of market value accounting contend that historical cost financial statements fail to reflect the underlying economic value of corporate entities in general and financial institutions in particular. SFAS 107 addresses this concern by requiring corporations with at least $150 million in total assets to report fair value estimates for all financial instruments, including those not recognized on the balance sheet. This standard marks a return to mandatory market value disclosures following the elimination of SFAS 33.

We focus our analysis on banks because financial institutions' balance sheets are dominated by the types of financial instruments covered under SFAS 107. Consequently, the relevance of fair value disclosures for such instruments is likely to be more pronounced for financial institutions than for other firms. The banking industry, however, has been reluctant to provide fair value disclosures. For example, the manager of accounting policy for the American Bankers' Association has stated: 'It will be very difficult to set a fair value for many commercial and industrial loans, which are often unique in value and lending t e r m s . . . That is why bankers are against such disclosure.' ( W a l l S t r e e t Journa l ,

December 17, 1991). The absence of market values for some financial instru- ments subjects their reported fair values to measurement error and managerial manipulation, potentially reducing such disclosures' reliability. A major objec- tive of this paper is to provide empirical evidence on the value relevance and reliability of the SFAS 107 disclosures.

While analysis of fair value disclosures under SFAS 107 is related to prior research on current cost estimates provided under SFAS 33, there are important differences between the two statements. In contrast to SFAS 33, disclosures under SFAS 107 are audited and, in particular for financial institutions, apply to the bulk of balance sheet accounts as well as off-balance-sheet items. While the first factor potentially improves the quality of disclosures, both factors serve to mitigate the problems of measurement error and correlated omitted variables. These problems precluded previous researchers from drawing reliable inferences about the value relevance of current cost disclosures under SFAS 33.

1 Even prior to SFAS 107, banks were required to disclose fair values of securities under Regulation S-X of the Securities and Exchange Commission (SEC).

E.A. Eccher et al. / Journal of Accounting and Economics 22 (1996) 79-117 81

An important feature of SFAS 107 is that it provides estimated fair values for individual financial assets and liabilities. From a valuation standpoint, these fair values are likely to be associated with share prices only to the extent that the market values of the individual financial instruments are correlated with ex- pected future cash flows of the firm. However, the value of a going concern (i.e., present value of the expected future cash flows) is likely to be greater than the sum of the reported fair values of individual assets minus liabilities due to the omitted value of 'goodwill'. Consequently, fair value estimates provided under SFAS 107 are incomplete due to the omission of important intangible assets representing the present value of expected future rents (e.g., value of trust department, value of trading activities, core deposit intangibles). Thus, the extent to which fair value disclosures are associated with market value of equity is an empirical issue.

This study also complements the growing literature on the value-relevance of market-value disclosures for financial institutions. Prior research has examined the value relevance of specific components such as market values of investment securities (Barth, 1994; Ahmed and Takeda, 1995; Philips and Mayne, 1970; Barth, Landsman, and Wahlen, 1995), or has examined fair value disclosures in settings where corresponding historical cost information is not available (e.g., Danish banks in Bernard, Merton, and Palepu, 1995). Our study focuses on the fair values of all the major on- and off-balance-sheet components and examines their value relevance in the presence of a wide range of historical-cost-based financial disclosures.

We examine the relevance and reliability of fair value disclosures using two sets of tests. First, we test whether the fair value disclosures are value-relevant after controlling for their historical cost book values. This is examined by regressing market-to-book ratios on the differences between reported fair values and their corresponding book values. We find that the fair value of investment securities are value-relevant even after controlling for the fair values of other financial instruments (see Barth, 1994; Petroni and Wahlen, 1995). This result is consistent with the evidence in the extant literature that banks do not earn 'rents' from investment in securities (see Heggestad and Houston, 1992) and, therefore, the fair values of securities are likely to be highly correlated with expected future cash flows from these assets.

The evidence on the new disclosures under SFAS 107 is mixed. We find that the fair value of net loans has a weaker association with market-to-book ratio than does the fair value of securities. While the off-balance-sheet instruments are value-relevant in limited settings, we find no significance for the fair value of deposits. The lack of significance for deposits could be due to the exclusion of core deposit intangibles in the valuation of deposits under SFAS 107. Overall, since the market values of individual assets and liabilities of financial institutions are more likely to reflect the expected future cash flows, one must be cautious in extending our limited findings to other industries.

82 E.A. Eccher et aL /Journal of Accounting and Economics 22 (1996) 79 117

The U.S. GAAP requirement that firms disclose historical-cost-based as well as fair-value-based disclosures raises the additional question of whether fair value disclosures, in general, have incremental value relevance, over and above historical cost financial statements taken in their entirety. This is examined through our second set of tests. To address the question of incremental value relevance, we begin by developing a benchmark model that explains variations in market-to-book ratios using only signals that are available from the tradi- tional historical cost accounting system. These signals capture attributes such as profitability, loan quality, capital adequacy, and liquidity that have been viewed in the extant literature as significant determinants of banks' market-to-book ratios (e.g., Beaver et al., 1989; Keeley, 1990; Sinkey, 1989; among others). From a valuation standpoint, these historical cost ratios are likely to complement fair value disclosures by providing information on the value of 'goodwill' not captured by the market values of individual financial instruments.

We augment our benchmark model with fair value data (disclosed both before and after SFAS 107) to assess their incremental value relevance. For the 1992 disclosures, we find that fair value information has incremental explanatory power, which suggests that disclosures on financial instruments enable the GAAP financial statements to become a more comprehensive source of value- relevant information. Specifically, including the fair value data increases the R-squared from 44% for the historical cost benchmark model to 63% when the model includes both fair value and historical cost data. For the 1993 disclosures, however, the significance of the fair value numbers is considerably weaker. The incremental informativeness of the fair value disclosures is at best marginal and is found only in limited settings.

Taken together, our results suggest that information on the fair value of individual financial instruments explains only a modest portion of the variation in market-to-book ratio. In contrast, the relative success of the traditional historical cost financial ratios indicates that the present value of expected future rents ('goodwill') is a significant component of firm value. This finding is important for standard setters examining the relative merits of switching to a market value accounting system.

We perform several tests to explore potential explanations for the decline in the value relevance of fair value disclosures for 1993, but do not obtain a domi- nant explanation for this result. However, these tests do suggest that the weaker results in 1993 are not necessarily due to increased measurement error in the fair value disclosures. Examination of data beyond our sample years could yield additional insights for this decline.

In Section 2, we briefly summarize the current debate on the pros and cons of historical cost versus fair value accounting and discuss the research questions. In Section 3, we develop our estimation equations and specify the hypotheses to be tested. Section 4 provides descriptive evidence on the fair value disclosures and reports the results of our empirical analysis, while Section 5 addresses the

E.A. Eccher et al. / Journal o f Accounting and Economics 22 (1996) 79-117 83

sensitivity of our findings to alternative model specifications. Concluding re- marks are provided in the final section.

2. The current debate on historical cost versus market value accounting

SFAS 107 evolved from the FASB's broader project on financial instruments and off-balance-sheet financing, which began in 1986. In Appendix C to the statement, the Board notes its belief that 'market value p r o v i d e s . . , another relevant measure for recognized financial instruments that are measured on other bases' (p. 25). The Board further notes that although the current statement deals only with disclosures, the Board is 'considering recognition and measure- ment issues in other parts of the project on financial instruments'.

Although welcomed by the SEC, the Exposure Draft for SFAS 107 was not well received by financial institutions. Of the 204 comment letters received by the FASB regarding this statement, 57 (28%) were submitted by banks, thrifts, and their representational organizations (e.g., American Bankers Association). 2 The overwhelming majority voiced strong objections to the Exposure Draft on topics ranging from the expected cost of implementation to beliefs that the required disclosures would be misleading rather than useful to investors. Many bank managers feared that requiring disclosure of fair values for all financial instruments, whether traded or not, inevitably would lead to recognizing these values in the financial statements.

The pros and cons of market value accounting for financial institutions have been discussed widely by academics, regulators, and business community members. 3 Proponents argue that market values provide relevant information about banks' economic health on a more timely basis than do historical costs, thereby leading to more timely regulatory intervention of troubled institutions (e.g., Berger et al., 1990; Bernard et al., 1995; Morris and Sellon, 1991). Converse- ly, defenders of historical cost accounting argue that the subjective assessments that underlie many market value estimates create the potential for greater measurement error and managerial manipulation (see, e.g., Beaver et al., 1992; U.S. Treasury, 1991). Other criticisms of market value accounting include its alleged propensity to create undue volatility in banks' capital ratios (i.e., in excess of the underlying cash flows' true volatility), its inability to alter manage- rial incentives to disclose private information, and the cost of implementation (e.g., Bernard et al., 1995; Kirk, 1991; U.S. Treasury, 1991; Beaver et al., 1992).

2 We use the terms bank and bank holding company interchangeably.

3 For example, see Beaver et al. (1992), Benston (1989), White (1991), Wyatt (1991), Christie (1992), O 'Hara (1993), and comment letters to the FASB concerning SFAS 107.

84 E.A. Eccher et al. /Journal of Accounting and Economics 22 (1996) 79 117

Enacted after extensive debate, SFAS 107 requires financial statement dis- closure of fair value estimates for all financial instruments, both recognized and off-balance-sheet, for fiscal years ending after December 15, 1992. The new fair value disclosures that result from SFAS 107 include fair value estimates for banks' loan portfolios, deposits, borrowings, and off-balance-sheet financial instruments, such as interest rate swaps, commitments, and derivative contracts. We focus our analysis on the value relevance of these new disclosures. In addition, we examine the incremental value relevance of all fair value disclosures over and above historical cost information already available under GAAP. 4

3. Development of the estimation equations and hypotheses

To develop an estimation model for testing the value relevance of fair value disclosures, we consider the following valuation model:

Firm Valuer= ~ 6*-" Et(CFO, (1) T = t + l

where 6 is the discount factor, E is the expectation operator, and CF is the cash flow from operations and investments. The value of equity can then be expressed as the difference between the firm value and the value of liabilities, i.e.,

M V E t = ~ 6 ~-' . E t ( C F 0 - - Z M V L i , t , (1') ~ = t + l i

where MVLi, t is the market value of liability i at time t. Since the firm's expected future cash flows are unobservable, an alternative

representation of firm value is to substitute the market values of individual assets that are expected to generate these future cash flows. Extant literature that examines the value relevance of accounting disclosures has taken a similar approach (e.g., Barth, 1991, 1994). The premise that underlies this approach is that the present value of expected future cash flows of a firm can be represented by aggregating the individual market values of its assets minus liabilities. However, this assumption is unlikely to hold for a going concern since the present value of its expected future cash flows is greater than the aggregated market values of its individual assets minus liabilities, i.e., the firm earns 'rents' (Smith and Watts, 1992). In essence, the market values of separable assets would be associated with the market value of equity only to the extent they are

4 The concurrent studies of Barth et al. (1995) and Nelson (1996) also investigate the value relevance of fair value disclosures under SFAS 107. While Barth et al. focus their analysis on the 150 banks in the compusta t database, Nelson's sample of about 140 banks is drawn from the 200 largest U.S. banks.

E.A. Eccher et aL / Journal o f Accounting and Economics 22 (1996) 79-117 85

correlated with expected future operating and investing cash flows (including abandonment cash flows). Therefore, when we express the market value of equity as the sum of market values of individual assets minus liabilities, we label the omitted expected future 'rents' as 'goodwill', i.e.,

MVE, = ~ MVAi,, - ~ MVL~., + GW, , i i

(2)

where MVA~,, is the market value of asset i at time t, MVL~., is the market value of liability i at time t, and GWt is goodwill at time t. For a financial institution, 'goodwill' includes rents generated by the trust department, derivatives business, mortgage servicing rights, ability to evaluate credit risk, control over operating costs, etc.

The framework in (2) enables us to predict when the market value of a given asset is likely to reflect the expected cash flows. For instance, empirical evidence suggests that banks typically do not earn significant 'rents' from their invest- ment in securities (see Heggestad and Houston, 1992). For such assets, the separate market values could well approximate the present value of the expected future cash flows. On the other hand, banks could earn substantial 'rents' from their lending operations, i.e., banks invest frequently in illiquid assets, such as loans, for which they have comparative informational advantage. Consequently, the 'market value' of the current portfolio of loans is unlikely to reflect fully the present value of the expected future 'rents' from their lending activities (Beaver and Demski, 1979).

Under SFAS 107, firms are required to provide estimates of market value (i.e., fair values) for all financial assets and liabilities. Since a bank's balance sheet consists mostly of financial instruments, we can substitute their fair value estimates under SFAS 107 for market values, i.e.,

MVE, = ~ FVAI,t - ~ FVLia + GW~ + ~,, (2') i i

where FVAi,t is the fair value of asset i at time t, FVLI,t is the fair value of liability i at time t, and e, represents the measurement error in fair value estimates.

By definition, book value of equity (B VE) equals the book value of recognized assets (BVA) minus the book value of recognized liabilities (BVL). The fair values of recognized assets and liabilities can deviate from their book values due to the historical cost principles of objectivity, conservatism, and going concern. The proponents of market value accounting have argued that the historical cost accounting system, therefore, does not measure changes in firm value on a timely basis. SFAS 107 partially addresses this concern by requiring manage- ment estimates of fair values for all financial instruments. However, the fair value estimates are also subject to measurement error and managerial discretion since the set of generally accepted principles for fair value accounting is not well defined.

86 E.A. Eccher et al. /Journal of Accounting and Economics 22 (1996) 79-117

In order to evaluate whether fair value disclosures are value-relevant over and above historical cost numbers, we transform Eq. (2') by adding and subtracting B V E ( = B V A - - B V L ) to the right-hand side and then deflating all terms by B V E , i.e.,

M V E t _ 1 + ~ F V A I ' t - BVAi , t _ ~ F V L i , t - B V L i , t

B V E t i BVE~ i B V E t

G W t et

+ BVE~t B V E ~ ' (3)

where B V E t is the book value of equity at time t, BVAI . t is the book value of asset i at time t, and B V L i . t is the book value of liability i at time t. Specified in deflated form, Eq. (3) has the econometric advantage of mitigating potential heteroskedasticity that is related to firm size. Conceptually, it focuses attention on the differences between the fair value estimates required by SFAS 107 and the historical-cost-based book values that have been the subject of criticism by proponents of market value accounting.

The first two components on the right-hand side of (3) (i.e., fair value minus book value of assets/liabilities) measure the extent to which the book value of equity fails to capture changes in the market values of individual assets and liabilities. The third component is the value of goodwill not reflected in the market values of individual assets and liabilities. Using the following regression model, we first examine whether fair value estimates (i.e., the first two compo- nents) are associated with the market value of banks, i.e., 5

M B = ~o + ~1 • A T R D F S + [32 • A I N V + ~3 " A N L

+ f14 " A D P W M + f15 " A L T D + f16 " M O B F V + ~, (4)

where

M B

A T R D F S

A I N V

A N L

A D P W M

= market value of equity divided by book value of equity, = fair value of securities available (or held) for sale and trading

securities minus their book value, divided by book value of equity, = fair value of investment securities minus their book value, divided

by book value of equity, = fair value of net loans minus their book value, divided by book

value of equity, -- fair value of deposits with maturity minus their book value,

divided by book vale of equity,

s Cash equivalents, preferred stock, other liabilities, short-term debt, and other assets each have only a handful of nonzero differences between fair and book values. Consequently, we exclude these balance sheet components from our regression models.

E.A. Eccher et al. /Journal of Accounting and Economics 22 (1996) 79-117 87

A L T D

M O B F V

= fair value of long- term debt minus its book value, divided by book

value of equity, and = fair value of market-re la ted off-balance-sheet items (with net

receivable/payable posi t ion coded as positive/negative), divided by book value of equity.

Banks ' securities portfolios consist of debt ins t ruments issued by Federal, state, and local governments , and their agencies, corporate equity and debt securities, mor tgage-backed securities, and debt securities of foreign govern- ments. Pr ior to SFAS 115, banks typically classified these securities into Secur- ities Held for Sale, which were carried usually at lower of amort ized cost or market value, and Inves tment Securities, which were booked at amort ized cost (Bank Letter, March 12, 1990). 6 Securities that were to be held on a long-term basis or for the foreseeable future were classified as Inves tment Securities (The

American Banker, July 16, 1992). 7 Unde r SFAS 115, the two comparable categories are labeled as Securities

Available for Sale and Securities Held to Matur i ty , respectively. As per SFAS 115, securities which the banks have the in tent and ability to hold to matur i ty are grouped under Securities Held to Maturi ty. With respect to the determina- t ion of book values, while Securities Held to Matur i ty cont inue to be valued at amort ized cost, Securities Available for Sale are now marked to market in the balance sheet with the after-tax unrealized gain or loss reflected in the book value of equity. Consequent ly , if the reported balance sheet values are used for these securities, A T R D F S would be zero for all the banks that early adopted SFAS 115 in 1993 (146 out of 328 banks in the 1993 sample). To enable compar i son with our analysis for 1992, we use the amort ized cost of Securities Available for Sale as a proxy for their book value in 1993. Analogously, we undo the after-tax adopt ion effect of SFAS 115 from the book value of equity when comput ing the marke t - to -book ratio.

Trading securities are typically marked to market both before and after the adoption of SFAS 115. However, in 1993, we found that the fair values of these financial instruments are different from their book values for Chase Manhattan Corp. and Continental Bank. Since we did not collect data on the breakdown between trading and available-for-sale securities, we have no statistics on such differ- ences during 1992. We, therefore, combine the two categories in our statistical analysis. Conse- quently, except for a handful of banks, A TRDFS captures essentially the unrealized gains/losses in securities available

7 Prior to SFAS 115, banks did not adopt uniform reporting practices for classifying securities into Held for Sale and Investment Securities. To address this concern, the SEC forced some banks to classify certain securities in their investment portfolio as Held for Sale by delaying their securities registration process or merger proposals if the banks had actively managed their securites portfolio, but listed them as Investment Securities in their balance sheets (The American Banker, June 17, 1992; The American Banker, July 16, 1992; Reuters, September 11, 1992). In addition, some of these banks were also required by the SEC to mark-to-market Securities Held for Sale.

88 E.A. Eccher et al. /Journal of Accounting and Economics 22 (1996) 79-117

Off-balance-sheet (OBS) items can be classified as either credit-related instru- ments, such as loan commitments and letters of credit, or market-related instruments, which include interest rate swaps, floors, caps, etc. (Rifle, 1995). Due to unresolved measurement and reporting issues, there are severe ambi- guities in interpreting the fair value disclosures for credit-related items, and therefore we exclude them from model (4). 8 However, since the fair value disclosures for market-related OBS instruments are, to a large extent, free from these ambiguities, we include M O B F V as an explanatory variable. 9

Note that our model (4) is an incomplete empirical adaptat ion of (3) for at least two reasons. First, model (4) does not directly capture the present value of expected future rents denoted earlier as 'goodwill'. Consequently, the signifi- cance of our fair value variables would reflect the extent to which the changes in the market values of individual assets and liabilities are associated with such future rents.

Second, although fair value estimates are available for most assets and liabilities of financial institutions, the disclosures under SFAS 107 are still incomplete. For instance, fair value estimates are not required for nonfinancial assets such as property, plant, and equipment. Consequently, model (4) suffers from an additional omitted variables problem.

In addition, there is a concern that measurement error in fair value estimates is likely to vary across different financial instruments. While market values of actively traded instruments such as marketable securities are readily available, the fair value estimates for inactively traded or nontraded instruments such as commercial loans could be subject to large measurement errors. We examine this possibility by estimating separate slope coefficients for fair value estimates of each major financial instrument.

Assuming no rents and disregarding the effects of correlated omitted vari- ables, we expect positive slope coefficients for all the asset variables (A TRDFS, A I N V , ANL, and M O B F V ) and negative slope coefficients for the liability variables ( A D P W M and ALTD). In addition, if measurement error is insignifi- cant, then the absolute value of the slope coefficients and the intercept would be unity.

Barth (1994) finds that fair values of securities, which banks disclosed even prior to SFAS 107, are significantly associated with banks' market value of

S A note discussing these issues is available from the authors. 9Among those reporting nonzero values for these items, some banks did not identify whether the figures shown represent net receivable or payable positions. For example, of the 109 (112) banks with nonzero notional values on interest rate swap contracts in 1992 (1993), 25 (18) did not identify the fair value as either a receivable or payable. Such ambiguous cases are excluded from our analysis.

E.A. Eccher et aL / Journal o f Accounting and Economics 22 (1996) 79- l 17 89

equity. Our primary research focus is the value relevance of new disclosures under SFAS 107, e.g., for net loans, deposits, long-term debt, and off-balance- sheet instruments. In order to underscore the distinction between the two sets of disclosures, we conduct two F-tests on the regression model (4) to examine the following null hypotheses:

Hla: The fair values of securities are not incrementally value-relevant over and above their historical cost values.

H~b: The fair value disclosures for financial instruments other than secur- ities are not incrementally value-relevant over and above their histori- cal cost values.

Hla is a re-examination of Barth's results in a multiple regression model in which fair value disclosures for major balance sheet components are jointly considered. In contrast, H~b is a test of the value relevance of the new disclosures mandated by SFAS 107.

We next extend our model by including other disclosures or proxies for financial instruments that were available prior to SFAS 107. Recall that model (4) excludes the reported fair values for credit-related OBS instruments due to measurement and reporting ambiguities. Even prior to SFAS 107, FASB had mandated disclosures on the contractual or notional values of OBS items under SFAS 105. With respect to the credit-related OBS instruments, their notional values are likely to be highly correlated with their expected fee revenue, the capitalized value of which would be reflected in the market-to-book ratio. Hence, following Rifle (1995), we include the notional value of credit-related items divided by the book value of equity (COBNV) as a proxy for the omitted fair value estimates. Based on our arguments, we expect COBNV to be positively related to the market-to-book ratio.

We acknowledge that the fair value disclosures for the OBS items might convey different information than their notional values. For instance, the no- tional value of credit-related instruments may be highly correlated with the present value of expected future rents (goodwill). In contrast, the fair value measures changes in the value of existin9 credit-related instruments. By includ- ing the notional values of the credit-related instruments, we examine jointly the value relevance of all new disclosures under FASB's recent push towards a market value accounting for financial instruments.

In a similar spirit, we include also the notional value of market-related instruments divided by the book value of equity (MOBNV) as an additional explanatory variable. These notional value numbers have been found to be value-relevant in Rifle (1995). As with the credit-related items, the notional values of market-related OBS items could proxy for the continuing stream of future cash flows that a bank might earn from related fees. Conversely, consis- tent with recent cases involving Bankers Trust and Barings, large notional

90 E.A. Eccher et al. / Journal of Accounting and Economics 22 (1996) 79 117

values for these ins t ruments could be a signal of impend ing losses. Hence, we do not predic t a d i rec t ion for the s lope coefficient of M O B N V . 1°

Anothe r f inancial asset we cons ider is the economic value of core depos i t intangibles , which has a t t r ac ted subs tan t ia l a t t en t ion from both banker s and researchers. 11 U n d e r S F A S 107, the fair value for deposi ts with no defined matur i t i es is requi red to be the a m o u n t paya b l e on d e m a n d at the repor t ing date, which is inva r i ab ly equal to its b o o k value. Since disc losure was not manda t ed , mos t banks d id not p rov ide es t imates for the fair value of core depos i t in tangib les tha t are e m b e d d e d in the economic value of these deposi ts . However , even p r io r to S F A S 107, the b o o k value of depos i t s with no s ta ted m a t u r i t y was publ ic ly avai lable . We, therefore, include the depos i t s with no s ta ted m a t u r i t y d iv ided by to ta l assets ( D P N M / T A ) as a con t ro l for the omi t t ed value of core depos i t intangibles.12 We expect a posi t ive s lope coefficient on this var iab le since core depos i t in tangibles are deemed to be va lue-enhancing.

By i nco rpo ra t i ng proxies for the omi t t ed f inancial ins t ruments , we augment the regression equa t ion (4) as follows, i.e.,

M B = flo + fll • A T R D F S + f12 " A I N V + •3 " A N L + f14 • A D P W M

+ f15 A L T D + [~6 " M O B F V + f17 " C O B N V + Ha " M O B N V

+ f19 D P N M / T A + e, (5)

where

C O B N V

M O B N V

= no t iona l value of c red i t - re la ted off-balance sheet i tems d iv ided by b o o k value of equity,

= no t iona l value of marke t - r e l a t ed off-balance sheet i tems d iv ided by b o o k value of equity,

D P N M / T A = depos i t s with no s ta ted m a t u r i t y d iv ided by to ta l assets,

1°Banks employ market-related OBS instruments for asset/liability management as well as to function as intermediaries/dealers. In the former scenario, the fair value disclosures under SFAS 107 can be examined to test whether banks employ off-balance-sheet instruments to effectively hedge against their exposure to financial risk from on-balance-sheet assets and liabilities. However, with respect to the market-related instruments arising from intermediaries/dealer positions, the fair value numbers are likely to provide an incomplete picture of the expected benefits/costs of such instru- ments.

11 See comment letters to SFAS 107, Brickley and James (1986), Marcus and Shaked (1984), Merton (1977), Pennacchi (1987), Ronn and Verma (1986), and Thomson (1987). Since the ability of banks to attract such deposits is tied to federally granted deposit insurance protection, these deposits represent a relatively inexpensive source of financing.

12Under SFAS 107, the fair value for deposits with no defined maturities is required to be the amount payable on demand at the reporting date, which is invariably equal to its book value. Hence, we do not include ADPNM in the regression since its value is always zero. Instead we include DPNM/TA, since the larger the proportion of deposits with no stated maturities to total assets, the larger is the expected effect of omitting core deposit intangibles from the regression.

E.A. Eccher et aL / Journal o f Accounting and Economics 22 (1996) 79 117 91

and other variables are as already defined. Model (5) includes either reported fair values or proxies for all major financial instruments of banks. We test the incremental contribution of the reported fair values of OBS items (i.e., M O B F V) using the following null hypothesis:

Hlc: The fair values of market-related off-balance-sheet items are not value-relevant over and above their notional values.

In the models developed above, we define value relevance to mean the extent to which the difference between the fair value disclosures under SFAS 107 and their historical cost counterparts are associated with the market- to-book ratio measured as of the end of the fiscal year (December 31). An important caveat here is that our analysis indicates only whether these fair value numbers are correlated with other value-relevant information used by the market. It is not possible to say from our study whether the fair value disclosures conveyed new information to investors.13

Our second set of tests examine if the fair value of the financial instruments provide incremental information after controlling not only for their book values, but also for other historical cost disclosures provided routinely in the financial reports. This aspect of the notion of relevance is expressed by the FASB in their conceptual framework:

The relevance of particular information about an item being considered for recognition cannot be determined in i s o l a t i o n . . . Relevance should also be evaluated in the context of the full set of financial statements with consideration of how recognition of a particular item contributes to the aggregate decision usefulness. (SFAS Concepts Statement No. 5, para 74)

Our valuation model (3) suggests that fair value estimates of individual assets and liabilities are unlikely to fully capture firm value since goodwill is disre- garded. Consequently, historical cost information is likely to be incrementally value-relevant over and above fair value disclosures to the extent it is associated with goodwill.

To define statistically this notion of incremental value relevance, we develop a benchmark model based on the historical cost accounting system to explain the cross-sectional variation in our dependent variable - market - to-book ratio (see Section 4.5 for implementation details). This approach provides a base against which to assess the incremental value relevance of all fair value dis- closures (on securities and other financial instruments) under SFAS 107. Al- though we expect the historical cost financial statements to provide information

13 Our sensitivity analysis using stock price data after the fiscal year end provides some evidence on the information content of the fair value disclosures. See Fn. 32.

92 E.A. Eccher et al. /Journal of Accounting and Economics 22 (1996) 79-117

on goodwill, they could also be indicators of the difference between market and book values of individual assets and liabilities. In summary, the extent to which the historical cost information supplement versus supplant the fair value dis- closures is an empirical question.

Similar to our earlier tests, we examine the incremental explanatory power of the fair value disclosures using the following null hypotheses:

Hza: The fair values of securities are not incrementally value-relevant over and above their historical cost values and other disclosures in the historical cost financial statements.

Hzb: The fair value disclosures for financial instruments other than secur- ities are not incrementally value-relevant over and above their histori- cal cost values and other disclosures in the historical cost financial statements.

H2a and Hzb examine the incremental contributions of fair value disclosures on securities and other financial instruments, respectively, in the presence of other information in historical cost financial reports. Since the notional value num- bers reported under SFAS 105 have been found to be value-relevant in Rifle (1995), we also test their marginal value-relevance using the following null hypothesis:

H2e: The notional values of off-balance-sheet instruments are not in- crementally value-relevant over and above the other disclosures in the historical cost financial statements.

In summary, FASB has mandated several new disclosures in the GAAP finan- cial reports as part of its financial instruments project. The three hypotheses above, taken together, test the incremental informativeness of the GAAP finan- cial reports in the presence of the new disclosures.

4. Empirical analysis of fair value disclosures

4.1. Sample selection and data collection procedures

Our sample consists of 296 (328) bank holding companies for the fiscal year 1992 (1993), representing a substantial majority of all publicly traded banks. All data on book and fair values for both years were hand-collected from annual or 10-K reports which were obtained directly from the sample banks. 14 We also

14 Some banks who supplied annual reports do not meet the SFAS 107 size test of $150 million in total assets and therefore are excluded form our sample. The rest of them did not respond to our two requests for annual reports.

E.A. Eccher et al. / Journal of Accounting and Economics 22 (1996) 79 117 93

obtained the not ional and fair values of off-balance-sheet items. The fair values were collected only for those items that are considered to be financial instru- ments under SFAS 107.15 Historical cost information and stock price data were obtained from a bank data base compiled by SNL Securities, L.P.

4.2. Descriptive information on fa i r value disclosures

The book value of total assets for our sample firms ranges from the SFAS 107 min imum size requirement of $150 million to about $214 billion, with a median of $1.5 billion in 1992. The book value of equity for 1992 ranges from about $2.0 million to more than $12.0 billion with a median of $117 million. The statistics for 1993 are similar.

Table 1 provides definitions and descriptive statistics for the book and fair values of individual assets and liabilities. ~6 The balance sheet componen ts expressed as a percentage of total assets indicate that the average bank in 1992 (using means) has 10.2% of its assets invested in cash equivalents, 26.7% in securities, and 57.6% in net loans. The assets are financed most ly by deposits representing 83.6% of the total, followed by 7.6% in owners ' equity (EQ) and 5.5% in short- term debt. The balance sheet composi t ion is very similar in 1993 except that the p ropor t ion of securities available for sale ( T R D F S ) in the total securities portfolio has increased due to the early adopt ion o f S F A S 115 by some of the sample banks.~ 7

Also reported in Table 1 are the mean differences between book and fair values for individual assets and liabilities. Overall, consistent with the low interest rate levels faced by banks during 1992 and 1993, the fair values of assets and liabilities are greater than their corresponding book values. Even though the percentage difference between book value and fair value is less than 3% for each of the balance sheet components , their combined effect results in the fair value of equity being greater than its book value (AEQ) by 16.1% in 1992 and 15.1% in 1993. This is because the fair values of assets reported under SFAS 107 exhibit a much larger deviation from their book values than do the liabilities. This evidence is consistent with concerns raised by the business communi ty

15 A handful of banks voluntarily disclosed fair value information for core deposit intangibles, trust department, mortgage servicing rights, premises, etc., which do not satisfy the GAAP definition of financial instruments. For example, 15 out of 296 banks in 1992 and l 1 out of 328 banks in 1993 provided fair value estimates for core deposit intangibles.

16 Since off-balance-sheet instruments do not have book values, we omit them from Table 1. They are expressed as a percentage of book equity and reported in Table 2. 17 As noted earlier, we substitute the amortized cost for the 1993 balance sheet value of securities available for sale. While our approach eliminates the unrealized gain/loss reported under SFAS 115, the proportion of securities reported in Table 1 as available for sale versus investment securities reflects the classification choice of the banks under SFAS 115.

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that, under SFAS 107, the asset side of the balance sheet would display larger volatili ty compared to the liability side since the fair value of deposits with no stated matur i ty must be reported at its book value. More important ly , the increased volatili ty in equity values derived using fair value estimates may not be commensura te with the changes in economic circumstances. 18

4.3. Descriptive statistics on dependent and independent variables

Table 2 reports mean values for the dependent and independent variables as

well as the correlat ions among them. To illustrate the cumulat ive effect on owners ' equity, we include also the percentage difference between the fair and book value of equity (AEQ) in Table 2.19 The statistics for 1992 and 1993 are

provided in panels A and B respectively. We find that ANL, ATRDFS, AINV, and A D P W M are the most impor t an t componen t s of AEQ. For example, in 1992, the mean ANL (13.18%) alone represents over 80% of the mean AEQ (16.12%).

The Spearman correlat ions in Table 2 indicate that the difference between the fair and book value of assets (ATRDFS, AINV, and ANL) are all significantly positively correlated with the marke t - to -book ratio. Cont ra ry to our expec- tations, we find that the liability variables, A L T D and A D P W M , are also positively associated with the marke t - to -book ratio in both years. However, univar ia te correlat ions should be interpreted caut iously since they are subject to omit ted variables bias. 2° When compar ing panels A and B, we find that the correlat ions of the fair value variables with MB is generally lower in 1993 than in 1992. This manifests clearly in the correlat ion between MB and AEQ, which decreased from 0.26 in 1992 to 0.17 in 1993. We investigate some potential explanat ions for this p h e n o m e n o n in Section 4.6.

~SThe 'economic circumstances' relevant from the stockholders' point of view are likely to be different from those for other stakeholders. Therefore, whether the value of deposit insurance (and/or the value of core deposit intangibles) should be included in the value of equity depends on the users' objectives. For example, '[-w]hile shareholders would prefer to include the value of the bank's option to default on its liabilities in the market value of net worth, debtholders and regulators would not because they would bear the cost of default' (Mondschean 1992, p. 24). See Berger et al. (1990) for a detailed discussion on this issue.

~9 Fair value of equity is defined as the sum of the fair values of all financial instruments as per SFAS 107 (excluding off-balance-sheet items) plus the book values of other assets minus the book values of other liabilities.

2o For example, assuming reasonable maturity matching, firms with the biggest losses on the liability side due to interest rate declines are likely to have the largest gains on the asset side. This relationship would manifest in a positive correlation between the asset and liability fair value variables, which may induce the observed positive correlation between the fair values of liabilities and market-to-book ratio. Consistent with this intuition, we find that ADPWM is highly positively correlated with ANL in both years.

96 E.A. Eccher et al. / Journal o f Accounting and Economics 22 (1996) 79-117

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Table 2 suggests that, of all the balance sheet components, only A N L and A I N V are highly correlated with AEQ, with A N L being the dominant of the two. However, A I N V exhibits a much stronger association with M B compared to any of the other variables in both years. Thus, even though the difference between book and fair value of equity appears to be dominated by the difference between book and fair value of loans, the market appears to perceive investment securities as being more value relevant. Both correlated omitted variables and differential measurement errors could explain this result (see Ahmed and Takeda, 1995). To focus on the latter issue, we next estimate the market-to-book ratio regressions in which the fair value variables are considered jointly.

4.4. Do fa i r value disclosures explain cross-sectional differences in market-to-book ratios?

Table 3 provides the results of estimating models (4) and (5). To examine the sensitivity of our results, we separately estimate model (5) for two subsamples of firms grouped by firm size as measured by total assets at the end of each of the sample years. The choice of firm size as a grouping variable is driven by two considerations. First, the evidence in Atiase (1985), Freeman (1987), and Collins et al. (1987) suggests that small firms have less pre-disclosure information than large firms due to differential private incentives for information collection. Second, the level of measurement error in fair value variables may also be related to firm size. For instance, larger banks are likely to invest in assets that are less frequently traded or for which they have greater informational advant- age, resulting in greater measurement error in their fair value estimates (Petroni and Wahlen, 1995). Thus, controlling for firm size appears to be important in evaluating the value relevance of fair value disclosures.

The results in Table 3 suggest that the fair value disclosures for the year 1992 are value-relevant. 21 In model (4), three of the six fair value variables are significantly associated with M B in the predicted directions at the 0.01 level. Both Hla and Hlb are rejected at conventional levels. With respect to individual coefficients, the statistical significance of A T R D F S and A I N V is consistent with the evidence in Philips and Mayne (1970) and Barth (1994). In addition, despite concerns raised about the potential for measurement error in valuing loans, the difference between the fair and book values of net loans appears to be value relevant. Although long-term debt is statistically significant, its slope coefficient has an unexpected sign. Moreover, neither deposits nor off-balance-sheet instru- ments explain the cross-sectional variations in MB.

21 In all regression models, outliers from the first pass regressions (defined by Cook D greater than one and/or the absolute value of studentized residuals greater than three) are eliminated and the models are re-estimated. In addition, firms with negative book values for owners' equity are also eliminated.

E.A. Eccher et al. / Journal of Accounting and Economics 22 (1996) 79-117 99

When we include the notional value variables as well as the control for core deposits, the adjusted R-squared increases from about 17% in model (4) to more than 28% in model (5). While the asset variables (ATRDFS, AINV, and ANL) continue to be significant, the long-term debt variable is not. As noted in Table 2, all three OBS variables have significantly positive correlations with ALTD. Consequently, including the OBS variables in the regression appears to have mitigated the spurious positive relation between ALTD and MB. Consistent with our prediction and prior evidence (see Rifle, 1995), the credit-related instruments are positively related to the market-to-book ratio. The negative coefficient that we observe for the notional value of market-related instruments (MOBN V) suggests that the market penalizes firms with sizable market-related OBS contracts. 22

The size-based regressions provide a somewhat different picture. Only AIN V is significant and has the expected sign in both size-based samples. While A TRDFS is significant only for large firms, ANL is positively related to MB only for small firms. The absence of significance for ANL for large firms is consistent with the earlier argument that the estimated fair values of the loan portfolios for these firms are likely to exhibit greater measurement error.

With respect to OBS items, the fair value of market-related instruments (MOBFV) is value relevant for large firms (p < 0.01). The negative slope coeffic- ient of MOBFV for small firms is based on only eight (five) nonzero observa- tions in 1992 (1993). In contrast, large firms have 62 (71) nonzero values in 1992 (1993) for MOBFV. In addition, the negative slope for these instruments' notional values (MOBN V) is driven by the subsample of larger firms. Both these results are consistent with the observation that larger firms are more likely to be actively engaged in risk management and more likely to act as intermedia- ries/dealers.

The results for 1993 are uniformly weaker across all models and for all variables. The explanatory powers of models (4) and (5) decrease substantially from 1992 to 1993. However, ATRDFS and AINV continue to be significant in the full sample across both specifications. While ANL is marginally significant in model (4), it is not significant at conventional levels in model (5) (one-tailed p-value = 0.103). In the size-based regressions, the adjusted R-squared for large firms is negative and the overall model is insignificant. Among the fair value variables, while ATRDFS is significant in both size-based samples, AINV is

22 While DPNM/TA is significantly associated with MB, the negative sign of its slope coefficient is inconsistent with our prediction. One possible explanation for this result is that banks with lower values for DPNM/TA might have invested a larger proport ion of their total assets in investments that earn substantial rents. Although our analysis is preliminary, we do find that in both 1992 and 1993 banks that have lower values for DPNM/TA also have a larger proport ion of total assets consisting of loans.

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value-relevant only in small firms. 23 None of the other fair value variables is associated with the market - to-book ratio.

Except for A T R D F S , the slope coefficients for the fair value variables are significantly different from unity. In addition, while the intercept variables are significantly positive in all the regression models, they also are significantly larger than one.

In summary, the results above suggest that only some fair value estimates are significantly associated with market - to-book ratio and that the strength of this relationship dropped substantially from 1992 to 1993. 24 In Section 4.6, we report the results of additional tests to examine potential reasons for the deterioration in the regression R-squared.

Taken together, our results so far suggest that differences between fair and book values of individual assets/liabilities have modest associations with mar- ket- to-book ratio. We next examine the value relevance of existing historical cost disclosures as well as the incremental value relevance of the fair value disclosures over and above the historical cost disclosures.

4.5. Are the fair value disclosures incrementally value-relevant over and above

the historical cost disclosures already available?

Given that the fair value disclosures apply to the bulk of banks' assets and liabilities, their explanatory power is rather modest. The regression adjusted R-squareds range from about 6% to 28% depending on the model specification and the sample period. In this section, we test the extent to which the fair value disclosures and the information available under the historical system substitute for and/or complement each other.

We develop initially a benchmark model based on the historical cost system to explain cross-sectional variations in the market - to-book ratio. The bench- mark model includes a set of financial signals that represent capital adequacy, profitability, loan quality, balance sheet structure, growth, and size, and are chosen to capture the broad set of historical-cost-based financial information available to the market. The eighteen financial signals that we consider are listed in Table 4. Although the chosen financial signals are unlikely to capture all the value relevant information in the financial statements, they consist of ratios that are typically considered vital to bank valuation (see, e.g., Beaver et al., 1989; Keeley, 1990; Rifle, 1995; Sinkey, 1989; Scholes et al., 1990; among others). Furthermore, these variables capture the five characteristics that are considered

23The 1993 results for ATRDFS are substantially weaker if the amortized cost of Securities Available for Sale is not defined as their book value. For instance, while A TRDFS is only marginally value relevant in small firms, it becomes insignificant in large firms. :4The tenor of this result is unaffected when March 31 market value of equity is substituted for year-end equity value.

E.A. Eccher et ctl. / Journal of Accounting and Economics 22 (1996) 79 117 103

essential by bank regulators, i.e., Capital adequacy, Asset quality, Management ability, Earnings level and quality, and Liquidity, which are collectively referred to as the CAMEL rating. 2s

Similar to Ou and Penman (1989), we estimate a step-wise regression for the pre-SFAS 107 period spanning the three years from 1989 to 1991 with MB as the dependent variable and the eighteen financial signals as possible independent variables. Based on a two-tailed alpha level of 0.15, we identify the variables that contribute significantly to explaining MB in the pre-SFAS 107 period. The benchmark model to evaluate the incremental value relevance of SFAS 107 disclosures includes only those historical cost variables that are significant in the step-wise regression model.

Using this procedure, we find that twelve variables are significant yielding an R-squared of 4 5 % . 26 Of these twelve variables, the ratio of noninterest income to net interest income (NONIINII) and the ratio of operating expenses to net interest income (OENII) are the most highly significant. This finding suggests that control over operating expense and income from alternative sources are among the most important discriminating variables in explaining cross-sec- tional differences in banks' market-to-book ratios. 27 The loan quality variables, the loans-to-deposits ratio, and several growth variables are significantly asso- ciated with MB in the expected directions. 2s Overall, we find that historical cost financial ratios explain a material portion of the cross-sectional variations in

25 For instance, equity to total assets (EQTA) is a measure of capital, loan loss reserve to nonperforming assets (LLRNPAD), and loan loss reserve to loans (LLRLLN) are measures of asset quality, operating expenses to net interest income (OENII) reflects management ability, net interest income to average earnings assets (NIIAEA), noninterest income to net interest income (NONIINII), and loan loss provision to net charge offs (LLPNCOt capture earnings level and quality, and loans to deposits (LNDEP) is an indicator of illiquidity.

~'~'In order to test the robustness of the benchmark model, we estimate the market-to-book regressions for 1992 and 1993 including only those historical cost signals that are significant during the period 1989 1991. This ex ante model has explanatory power of 43.5% in 1992 and 32.5% in 1993. These statistics compare favorably to the adjusted R-squareds of 45.8% in 1992 and 34.5% in 1993 obtained from an ex post model in which the signals are chosen from a step-wise regression model using each year's data.

27 Note that noninterest income includes items such as trust department income, fees and charges on deposit accounts, and trading income. Consequently, NONIINII is likely to represent the value of expected future rents that are not specifically considered in the fair value estimates of individual assets (e.g., value of trust department, value of trading activities).

2~ Loan loss reserve divided by loans (LLRLLN) is a measure of loan quality, i.e., the higher the ratio, the lower is the quality of loans. Consistent with this intuition, we find its slope coefficient to be negative. Conversely, loan loss reserve divided by nonperforming assets (LLRNPA D) is an indicator of managerial conservatism in estimating bad debts. Banks with higher values of this ratio are likely to have adequately provided for expected loan losses, so its positive coefficient is consistent with the capital market rewarding managers who follow conservative accrual policies. The ratio of loans to deposits (LNDEP) is a measure of relative illiquidity, i.e., the bank is borrowing short-term and

104 E.A. Eccher et al. /Journal of Accounting and Economics 22 (1996) 79 117

Table 4 Results of estimating the historical cost benchmark model, step-wise regression of market-to-book ratio on historical cost financial ratios, estimation period includes 1989 to 1991 (N = 956)

(1) (2) (3) (4) Financial Proxies from historical cost financial Parameter characteristic statements estimate t-statistic

Size

Capital

Profitability

Loan quality

Balance sheet structure

Growth

Log of total assets (LOGTA) 0.067 6.96**

Equity/Total assets (EQTA) EQTA 2

Net interest income/Avg, earnings assets 4.232 3.20** (NIIAEA)

Noninterest income/Net interest income (NONIINII) 1.303 15.84**

Operating expense/Net interest income (OENII) - 1.192 - 13.76"* Security gains and losses/Net interest income

(SGLNII) 0.612 2.21 * Nonrecurring items/Net interest income (NRNII)

Loan loss provision/Net interest income (LLPNII) Loan loss provision/Net charge offs (LLPNCO) 0.029 3.39** Loan loss reserve/(Nonperforming assets

+ Loans 90 days past due) (LLRNPAD) 0.067 4.54** Loan loss reserve/Loans (LLRLLN) - 8.386 - 6.66**

Loans/Deposits (LNDEP) - 0.457 - 4.48** Average loan/Average total assets (ALNA TA)

Dividend yield (DY) - 3.374 - 8.79** Asset growth (ASTG) Deposit growth (DPSTG) - 0.397 - 2.86** Loan growth (LOANG) 0.512 3.70**

Adjusted R 2 45.04%

The eighteen variables listed in column (2) are chosen initially as financial signals that represent capital adequacy, profitability, loan quality, balance sheet structure, growth, and size to capture the broad set of historical-cost-based financial information available to the market. A step-wise regres- sion model is estimated for the pre-SFAS 107 period spanning the three years from 1989 to 1991 with market-to-book ratio as the dependent variable and the eighteen financial signals as possible independent variables. Based on a two-tailed alpha level of 0.15, variables that contribute signifi- cantly to explaining the market-to-book ratio are included in the benchmark model. The results of the step-wise procedure are reported in columns (3) and (4) which include only those historical cost variables that are significant in the step-wise regression model. A ** ( * / # ) indicates statistical significance at the 0.01 (0.05/0.10) level, one-tailed t-tests.

investing in long-term illiquid assets. Thus, we expect and find LNDEP to be negatively associated with MB. Growth in investments (loan growth) is positively associated with market-to-book ratio, whereas growth in liabilities (deposit growth) is negatively related. The negative slope coefficient for dividend yield is consistent with the intuition that firms with larger assets-in-place relative to growth opportunities are likely to have higher dividend yields (Smith and Watts, 1992).

E.A. Eccher et al. / Journal of Accounting and Economics 22 (1996) 79 117 105

MB. This suggests that information in historical cost financial statements is significantly associated with the present value of expected future rents.

To test the three incremental value relevance hypotheses discussed in Section 3, we regress MB on the nine fair/notional value variables and the twelve financial signals. 29 The results for the full sample as well as for the two size-based samples for years 1992 and 1993 are provided in Table 5.

The overall model for 1992 is statistically significant and has an explanatory power of over 60% compared to an adjusted R-squared of 43.5 % (not reported) when only historical cost signals are included in the model. The three hypo- theses, Hza-Hzc are rejected at conventional levels, suggesting that the fair and notional value disclosures are each incrementally value relevant. With respect to the individual fair value variables, while ATRDFS and AINV retain their statistical significance, the slope coefficient of ANL is not statistically different from zero, In addition, ALTD now has a negative slope coefficient consistent with our expectations, and it is statistically significant at the 0.01 level. Thus, one possible explanation for not finding a negative slope coefficient for ALTD in earlier regressions is the effect of correlated omitted variables. The inclusion of the historical cost variables appears to have resolved this problem.

For 1992, the results for the size-based samples are consistent with those obtained in the full sample. The F-tests indicate that the fair and notional value variables are each incrementally value relevant for both large and small firms. All fair value variables that are significant in Table 3, i.e., A TRDFS, AINV, and MOBFV, continue to be significant for large firms even after adding the twelve historical cost signals to the regression model. With respect to small firms, while AINV is no longer significant, ALTD has a negative slope coefficient which is significant at the 0.01 level. More importantly, ANL retains its value relevance despite the addition of several historical signals on loan quality. Taken together, the results for 1992 suggest that the fair value disclosures under SFAS 107 are incrementally value-relevant after incorporating information from the historical cost financial statements.

The regression results for 1993, reported in Table 5, are consistently weaker than those for 1992. The F-tests fail to confirm the incremental value relevance of the fair value disclosures for financial instruments other than securities. Fair values of securities and the notional values of OBS items are significant both in the full sample as well as in the subsample of smaller firms. In essence, the results in panel B suggest that, apart from the fair value of securities, none of the other fair value variables is incrementally value-relevant in 1993.

29One might argue that our tests tor incremental value relevance are biased against finding significance for the fair value variables since we do not consider fair value counterparts to the historical cost ratios included in our model. While this argument has some merit, we are unable to identify such fair value counterparts for most of our historical cost variables using the limited disclosures available under SFAS 107.

106 E.A. Eccher et al. / Journal o f Accounting and Economics 22 (1996) 79-117

Table 5 Tests of incremental contribution of fair value variables over historical cost financial ratios, results of regressing market-to-book ratio on fair value and historical cost variables

Parameter estimates for 1992 Parameter estimates for 1993

All firms Large firms Small firms All firms Large firms Small firms Variable (N = 257) (N = 122) (N = 135) (N = 252) (N = 132) (N = 120)

Intercept 0.853* 1.107" 1.281 1.470"* 1.917"* 1.217

A T R D F S 1.329" 1.684" 0.237 1.037" 0.495 1.737"

A I N V 1.215"* 0.749 ~ 0.831 0.833 # - 0.391 1.415 ~

A N L 0.146 - 0.087 0.389* 0.002 0.039 0.095 A D P W M 0.186 0.147 0.377 0.861" 2.284** 0.323 A L T D - 3.143"* - 1.609 -- 3.414"* - 1.011 0.752 -- 1.652

M O B F V 0.676 2.566** - 7.665** 0.416 - 0.307 - 104.020

C O B N V - 0.021" - 0.032** - 0.001 - 0.021" - 0.021 # - 0.002 M O B N V - 0.004** - 0.004** 0.147"* - 0.006** - 0.005** 0.945 D P N M / T A -- 0.116 0.029 -- 0.426* -- 0.217 # - 0.147 -- 0.142 L O G T A 0 . 0 8 4 * * 0 . 0 2 5 0 . 0 9 9 * 0 . 0 5 4 * * - 0 . 0 1 5 0 . 0 6 2

N I I A E A 5.775* 15.136"* 2 . 7 4 4 3 . 2 0 0 17.279"* - 0 . 7 4 2

N O N I I N I I 1.960"* 2.149"* 1.380"* 1.287"* 1.689"* 0 . 8 6 4 * *

OENI1 - 1 . 5 8 1 " * - 1 . 5 1 4 " * - 1 . 5 5 4 " * - 1 . 1 8 2 " * - 1 . 2 2 1 " * - 0 . 8 9 4 * *

SGLNII 1 . 2 8 6 " * 0 . 1 8 5 1 . 5 0 7 " * 0 . 7 2 8 # 0 . 6 4 3 1 . 3 3 6 ~

LLPNCO - - 0 . 0 5 1 " - - 0 . 1 0 3 " - - 0 . 0 3 6 - 0 . 0 1 3 0 . 0 2 5 # - 0 . 0 2 0

LLRNPAD 0 . 0 9 7 * * 0 . 1 7 6 " * 0 . 0 5 2 0 . 0 6 1 " * 0 . 0 2 8 0 . 0 6 6 *

LLRLN - 2 . 1 6 9 - - 1 . 0 9 6 - - 5 . 1 6 3 - - 3 . 3 6 0 # - 5 . 6 2 7 ~' - 1 . 3 2 8

LNDEP - 0 . 1 1 0 - 0 . 0 0 3 - 0 . 2 6 3 - 0 . 0 7 1 - - 0 . 0 0 1 - - 0 . 1 5 1

D Y - - 1 . 4 6 9 1 . 1 1 5 - 4 . 9 1 4 " - - 5 . 9 9 8 * * - - 1 0 . 9 7 7 " * - 3 . 8 9 2

DPSTG - 0 . 1 9 4 0 . 1 7 4 - 0 . 1 4 3 - 0 . 2 5 5 0 . 0 9 9 - 0 . 2 6 2

LOANG 0 . 3 4 3 - - 0 . 2 0 0 0 . 2 0 1 0 . 0 7 1 - - 0 . 3 3 0 0 . 4 1 1

F(model) 21.37"* 12.09"* 9.38** 8.82** 5.52** 3.88** Adj. R z 62.55% 65.80% 56.77% 39.56% 42.01% 33.70% F(H2~) 5.41"* 2.60 # 0.68 2.77 ~ 0.67 2.58 ~ F(H2b) 7.24** 2.12 '~ 6.64** 1.22 1.92 0.25 F(H2c) 19.38"* 17.70"* 5.34** 11.32"* 9.08** 0.45

The market-to-book ratios are measured as of December 31. D P N M / T A = deposits with no stated maturity divided by book value of total assets. The historical cost financial ratios are bold faced. Refer to Table 2 (Table 4) for definitions of fair and notional value variables (historical cost financial ratios). A ** ( * / # ) indicates statistical significance at the 0.01 (0.05/0.10) level, one-tailed for t-tests (two-tailed for F tests). The coefficients for fair value asset (liability) variables and the intercept are italicized when the null hypothesis that they are equal to one (minus one) is not rejected at the 0.10 level, two-tailed tests.

T h e i n c l u s i o n o f t h e h i s t o r i c a l c o s t r a t i o s a p p e a r s to h a v e i m p r o v e d t h e

r e g r e s s i o n s p e c i f i c a t i o n . I n c o n t r a s t t o t h e r e s u l t s r e p o r t e d in T a b l e 3, w e n o w

f ind t h a t t h e i n t e r c e p t e s t i m a t e s a r e s t a t i s t i c a l l y i n d i s t i n g u i s h a b l e f r o m t h e

t h e o r e t i c a l v a l u e o f one .

E.A. Eccher et al. / Journal o f Accounting and Economics 22 (1996) 79- l l 7 107

In summary, the results for 1992 versus 1993 provide a contrasting view of the incremental value-relevance of the fair value disclosures. The results in this section suggest that relative to a broad set of information variables available to the market participants, at least some fair value disclosures are considered value-relevant in the year 1992, though not in 1993. More importantly, our results indicate the importance of existing historical cost disclosures in explain- ing bank equity values.

4.6. Diagnostic tests

In this section, we discuss the results of several diagnostic tests which are designed to investigate the low explanatory power of the market-to-book regressions in 1993.

To control for any nonlinearities in the model (see Freeman and Tse, 1993) we conduct a rank regression where we regress the rank of the dependent variable on those of the independent variables. While this approach increases the regression R-squareds for model (5) by about two percentage points in both 1992 and 1993, the inferences from our results are essentially unaltered.

We also test whether the low R-squared for 1993 is due to differences in the sample firms between the two years by identifying the set of firms that have fair value data for both years (about 240 firms). Using this sample of firms, we re-estimate model (5) for both 1992 and 1993. Similar to our results in Table 3, the adjusted R-squared for 1992 is 26.05% compared to 8.25% in 1993. This analysis indicates that even for the same set of banks, the association between market-to- book ratio and the fair value variables has deteriorated from 1992 to 1993.

Another possible explanation for this result is that banks might have become indifferent toward computing the fair value numbers, resulting in less reliable fair value estimates. 3° To address this issue, we mismatch the dependent and independent variables between the two years and re-estimate model (5) for both years. When we regress the 1993 market-to-book ratio on the 1992 fair value variables, the explanatory power of the 1992 variables decreases from 28% in Table 3 to 10%. This result is consistent with significant changes in the fair value estimates from 1992 to 1993 which are reflected in the 1993 market-to-book ratio. However, when the 1992 market-to-book ratio is regressed on the 1993 fair value variables, the explanatory power of the latter increases from 11% in Table 3 to 22%. More importantly, the t-statistic for ANL increases from 1.27 to 4.18. These results suggest that the lower explanatory of the fair value variables in 1993 is not necessarily due to higher measurement error in the 1993 fair value

30 In the 1995 Price Waterhouse Symposium, a senior vice president of a money center bank commented that although his bank has provided the SFAS 107 disclosures for the last three years, no financial analyst has so far called his firm to discuss any of the information in the fair value footnote.

108 E.A. Eccher et al. / Journal of Accounting and Economics 22 (1996) 79-117

estimates. Instead, they are consistent with the existence of omitted variables that have contributed to the variability in the 1993 market-to-book ratio. This conjecture is strengthened further by our earlier finding that the explanatory power of even the benchmark market-to-book ratio has decreased by more than ten percentage points from 1992 to 1993. We performed some descriptive analysis comparing the distribution of M B and changes in M B over the period 1989 through 1993. However, we could not identify any empirical regularity that might explain our results for 1993. We next investigate the sensitivity of our results to alternative regression specifications.

5. Tests of value relevance using alternative model specifications

Testing the value relevance of fair value numbers by associating them with M B is in line with the recent interest in the accounting literature on understand- ing the accounting determinants of market-to-book ratio (e.g., Penman, 1993; Bernard, 1994; Beaver and Ryan, 1993; Ryan, 1995). However, two alternative specifications have been employed in the extant literature to test for the value relevance or information content of accounting disclosures. These alternatives are: undeflated levels regressions (e.g., Landsman, 1986; Beaver et al., 1989; Barth, 1991, 1994; Barth et al., 1991; Barth et al., 1995) and regressing stock returns on accounting information (e.g., Barth, 1994; Nelson, 1996). Both models enable us to compare our results with those in the extant research on fair value disclosures (Barth, 1994; Barth et al., 1995). The returns specification also is expected to provide a better control for the bias from correlated omitted variables (Christie, 1987). We next discuss the sensitivity of our results to these alternative model specifications.

5.1. Results o f levels specification

To facilitate comparison with Barth et al. (1995), hereafter BBL, we regress the difference between the market and book values of equity (denoted M_B) on the undeflated differences between the fair and book values of balance sheet compo- nents as well as the notional value of off-balance-sheet components. Analogous to BBL, our levels specification includes the book value of property, plant, and equipment and other assets not covered by SFAS 107 (NONIO7AS) . We also include a variable to capture short-term debt and liabilities not covered by SFAS 107 (NONIO7LI ) . To capture default risk, we include nonperforming assets and loans 90 days past due in our N P A 9 0 D variable. 31

3 ~ Due to both nonavailability of data for our larger sample and the insignificance observed in BBL, we do not include a proxy for net pension asset/liability. We also do not include a proxy for 'duration gap' since it is available in our database only for a subset of firms. As acknowledged in

E.A. Eccher et al. / Journal of Accounting and Economics 22 (1996) 79-117 109

The results from this levels specification are reported in Table 6. Consistent with the marke t - to -book specification reported in Table 3, we report results of the levels specification for the full sample as well as for the two size-based subsamples. In three out of the six regressions, we reject the null hypothesis of homoskedast ic i ty and correct model specification using White 's test (~ -- 0.10). Therefore, we evaluate significance levels using test statistics that have been adjusted for heteroskedasticity.

While the regression R-squareds are higher (as expected) for the levels model, our main inferences from the M B regressions are essentially unaltered. Similar to the results in Table 3, A T R D F S and A I N V are significantly associated with M _ B in the full sample for the year 1992. For large (small) firms, A T R D F S and A I N V ( A I N V and ANL) are statistically significant with the correct sign for 1992 in the levels and the marke t - to -book ratio specifications. However, M O B F V is no longer significant at convent ional levels for large firms. In 1993, the results for the full sample are slightly weaker in Table 6 compared to those in Table 3, whereas the results in the size-based samples are somewhat stronger in the levels model. Overall, while the two approaches provide somewhat different results, the tenor of our findings remains unchanged. 32

5.2. Results o f returns specification

In an efficient market, stock returns reflect, among other things, unanticipated changes in the fair value of assets and liabilities during the return interval. Disregarding changes in the value of goodwill, changes in fair values of indi- vidual assets and liabilities are likely to capture these unanticipated changes. Such an approach would be analogous to regressing stock returns on earnings changes which is a frequently used research design in earnings returns studies (hereafter, the earnings change model). However, the evidence in recent research (Kothari , 1992; Kothar i and Sloan, 1992; Eas ton and Harris, 1991; Easton, Harris, and Ohlson, 1992) suggests that a returns model in which the level of

BBL (p. 16), proxies for interest rate sensitivity are, to some extent, captured in the SFAS 107 variables. Thus, the difference between our levels specification and that in BBL is not merely restricted to sample size. However, the results of our levels regression are consistent with those in BBL. 3 z We replicate our levels regressions using March 31 prices also. For 1992, the results are consistent with those obtained using December 31 prices. However, for 1993, the coefficients for net loans are significant overall as well as in both size groups when March 31 prices are used (see BBL for a similar result). We obtain comparable results when we replicate our market-to-book regression models reported in Table 3 using March 31 prices. This suggests that we must interpret with caution the lower explanatory power of the 1993 regressions when the market value of equity is defined using December 31 prices. In essence, while the fair value disclosures might have provided new informa- tion to the market, our analysis using December 31 prices could have lacked the power to find value relevance.

110 E.A. Eccher et al. / J o u r n a l o f Account ing and Economics 22 (1996) 79 117

Table 6 Results of regressing the difference between m a r k e t and book value of equi ty on the differences

between the fair value and b o o k value of assets and l iabi l i t ies

Var iable

Results for 1992 Results for 1993

All firms Large firms Small firms All firms Large firms Small firms

(N = 257) (N = 119) (N = 135) (N = 279) (N = 134) (N = 148)

Intercept 5.849 36.327 - 3.851 26.178"* 55.847** 1.127 A T R D F S 1.860" 2.002 # O. 709 1.480 O. 602 2.165** A I N V 1.330"* 1.085"* 1.838"* 2.705** 3.492** 3.116"*

A N L 0.120 0.010 0.956** 0.208 - 0.069 0.434 + L I D P W M 2.369** 1.260 - 0.062 0.596 2.381"* - 0.061

A L T D - 0.113 2.725 1.759 0.005 - 1.955" 1.938

M O B F V 1.211 2.162 - 18.600"* 0.431 0.294 - 162.758

C O B N V - 0.021 0.019" - 0.008 0.043** 0.050** 0.023 +

M O B N V - 0.002* - 0.003* 0.415"* - 0.002 0.0003 1.169 D P N M 0.030* 0.035 # -- 0.011 0.040** 0.04l** 0.006

N O N I O 7 A S 0.347* 0.266 0.533** - 0.157 - 0.075 0.243 N O N I O 7 L I 0.095** 0.100" 0.070 0.064* 0.012 0.043

N P A 9 0 D - 0.612"* - 0.682** - 0.523** - 0.886** - 0.982** - 0.421"*

p-values f rom Whi te ' s Z 2 White ' s ~(2 t -s ta t is t ic Whi te ' s Z 2 t -s tat is t ic t -s tat is t ic

Adj. R E 92.76% 84.99% 57.32% 94.44% 94.61% 47.47%

All var iab les are measured as of December 31. T R D F S = t rad ing securi t ies and securi t ies ava i lab le for sale, I N V = securit ies held to ma tu r i t y or inves tment securities, N L = net loans, D P W M =

deposi t s wi th s ta ted matur i ty , L T D = long- te rm debt, M O B F V = fair value of marke t - r e l a t ed

off-balance-sheet ins t ruments , C O B N V = no t iona l va lue of credi t - re la ted off-balance-sheet instru-

ments , M O B N V = no t iona l va lue of marke t - r e l a t ed off-balance-sheet ins t ruments , D P N M = b o o k value of deposi t s wi th no s ta ted matur i ty , N O N I O 7 A S = b o o k value of proper ty , plant , and

equ ipmen t plus the b o o k value of o ther assets, N O N I O 7 L I = b o o k value of shor t - te rm debt plus the book value of o ther l iabil i t ies, and N P A 9 0 D = nonpe r fo rming assets plus loans 90 days pas t due. A refers to the fair value minus the b o o k value of the no ted variable. For 1993, the amor t i zed cost is

subs t i tu ted for the b o o k value of securi t ies ava i lab le for sale. A * * ( * / + ) indicates s ta t is t ical s ignif icance at the 0.01 (0.05/0.10) level, two- ta i led tests. White ' s specification test is per formed using an a lpha of 0.10. The coefficients for fair va lue asset (liability) var iab les are i ta l icized when the null

hypothes i s t ha t they equa l one (minus one) is no t rejected at the 0.10 level, two- ta i led tests.

information (e.g., earnings level) is employed as the independent variable is better specified - the earnings level model. 33 We, therefore, consider the following returns specification in which the levels of(rather than the changes in) fair values in excess of book values are incorporated as independent

33 TWO a r g u m e n t s are advanced for the success of the earn ings levels model . First , def la t ing earn ings level by the s tock price a t the beg inn ing of the re turn in terval in effect e l imina tes the expected c o m p o n e n t of ea rn ings (Kothar i , 1992, p. 185). Second, in con t ras t to the earn ings change model , the earn ings level mode l offers a be t te r specif icat ion for mi t iga t ing the effects of measu remen t er ror in

E.A. Eccher et al. / Journal o f Accounting and Economics 22 (1996) 79 117 11 I

variables, i.e.,

• R e t = flo + fl~ • A T R D F S + f12 " A I N V + f13 " A N L + f14 " A D P W M

+ f15 " A L T D + f16 " M O B F V + f17 " C O B N V + f18 " M O B N V

+ f19 " D P N M / T A + f l l o • I B E D + ~;,

where R e t is the 15-month stock returns for the fiscal year plus the ensuing three months , all the fair and no t iona l value variables are deflated by the market value

of equity as of the beginning of the return cumula t ion period ( M V E t 1), and A refers to the excess of fair value over book value. The 15-month re turn interval ensures that the fair value disclosures were available to the market par t ic ipants

(see Collins and Kothar i , 1989). A l imitat ion of our regression specification, however, is that only a por t ion of

the differences between fair and book values reported at the end of a given fiscal year is likely to have arisen within that fiscal year. Tha t is, some of the unrealized gains (losses) would reflect economic events from earlier account ing periods,

result ing in model misspecification. Even though deflation by M V E t 1 partially addresses this concern (Kothari , 1992), we further improve our model specifica- t ion by re-est imating our returns model using a three-year cumula t ion period for returns. For instance, when the independent variables are the excess of 1992 fair values over book values, the dependent returns variable is measured over

the period from January 1990 through March 1993, and the deflator is the market value of equity as of December 31, 1989 (Kothari and Sloan, 1992). 34 As a proxy for existing historical cost informat ion, we include the level of income before ext raordinary items and discont inued operat ions measured over the return interval, divided by M V E t _ 1 (denoted I B E D ) as an addi t ional explana- tory variable (see Eas ton and Harris, 1991; Kothar i and Sloan, 1992).

earnings (Easton et al., 1992). Although we focus on the levels model, the choice between the earnings levels and the the earnings change specifications is ultimately an empirical issue. Therefore, when relating our research to the extant literature (see Section 5.3), we discuss the results from the change specification also.

3'~Barth (1994) regresses multi-year stock returns on the fair value of security gains and losses cumulated over the corresponding multi-year return interval. Compared to annual return models, she finds that the t-statistic for the fair value variable increases with the cumulation period of up to four years. Barth (1994) suggests that the improved explanatory power of the long-window models is consistent with significant measurement error in the fair value estimates of securities. If measurement error is a concern for securities, which are more likely to have 'market' prices, then the use of long-window models may be even more appropriate for thinly traded assets such as net loans. However, since data is available only for two years for most fair value variables, we use the difference between year-end levels of fair and book values as a proxy for the aggregated change in fair values used in Barth (1994).

112 E.A. Eccher et al. /Journal of Accounting and Economics 22 (1996) 79 117

In T a b l e 7, we r e p o r t t he resu l t s o f the r e t u r n s r eg ress ions . T h e s e resu l t s a re

c o n s i s t e n t w i t h t he va lue r e l e v a n c e o f fair va lue d i sc losu res . I n d e e d , the resu l t s in

T a b l e 7 a re u n i f o r m l y s t r o n g e r c o m p a r e d to t h o s e r e p o r t e d in T a b l e 3. W e f ind

t h a t severa l fair va lue va r i ab l e s (A T R D F S , A I N V , A N L , A L T D , a n d A M O B F V )

are s ign i f i can t ly a s s o c i a t e d wi th b a n k s ' s t o c k r e t u r n s (wi th c o r r e c t s igns) d u r i n g

both 1992 and 1993. W i t h r e spec t to A T R D F S , we f ind (no t r e p o r t e d in o u r

tab les ) t h a t s u b t r a c t i n g the amort i zed cost ( ins t ead of the book value) w h e n

c o m p u t i n g the fair va lue va r i ab l e i nc r ea se s t he s ign i f i cance level o f its s lope

Table 7 Results of regressing stock returns on the excess of fair value over book value of assets and liabilities

One-year cumulation period Three-year cumulation period

1992 1993 1992 1993 Variable (N = 241) (N = 261) (N = 225) (N = 228)

Intercept 0.059 -- 0.010 0.132 0.635** A TRDFS 2.060** 0.974** 2.857** 1.778** AINV 2.246** 0.454 3.097** 2.247** ANL 0.622** 0.297** 0.883** 0.963** ADPWM 0.977** 0.117 0.329 0.097 ALTD - 3.799** - 1.397" - 1.738 ~ 1.111 AM O BFV 2.954"* 1.169" 2.066" 1.717" COBN V 0.023** 0.003 0.007 0.013* MOBNV -- 0.001 -- 0.0003 -- 0.001 -- 0.002* DPNM/TA 0.141 0.201"* - 0.391" - 0.135 IBED 1.197"* 0.411"* 1.040"* 0.408"*

F-value 21.91"* 5.24** 37.30** 17.16"* Adj. R z 46.56% 14.03% 61.84% 41.59%

The dependent variable in the one-year model is the raw returns from the beginning of the fiscal year to the end of the third month of the following fiscal year. The cumulation period in the three-year model begins 24 months prior to the beginning of the cumulation period in the corresponding one-year model. DPNM/TA = deposits with no stated maturity divided by book value of total assets, TRDFS = trading securities and securities available for sale, INV = securities held to maturity or investment securities, NL = net loans, DPWM = deposits with stated maturity, LTD = long-term debt, MOBFV = fair value of market-related off-balance-sheet instruments, COBNV = notional value of credit-related off-balance-sheet instruments, MOBNV = notional value of market-related off-balance-sheet instruments, and IBED = income before extraordinary items and discontinued operations. A refers to the fair value minus the book value of the noted variable. For banks that had adopted SFAS 115 in 1993, the amortized cost of securities available for sale is substituted for its book value. In the one-year model, IBED of the corresponding year is used. In the three-year model, IBED is the sum of the income figures for the current and the prior two years. Except for DPNM/TA, all the other independent variables are deflated by the beginning of the return cumulation period market value of equity. The coefficients for fair value asset (liability) variables are italicized when the null hypothesis that they equal one (minus one) is not rejected at the 0.10 level, two-tailed tests. A ** ( * / * ) indicates statistical significance at the 0.01 (0.05/0.10) level, one-tailed t-tests.

E,A, Eccher et aL / Journal of Accounting and Economics 22 (1996) 79 117 113

estimate in 1993. In addition, the slope coefficient of A L T D in the returns model is statistically significant and has the correct sign in both years. This evidence is consistent with our earlier argument that the returns specification offers a better control for the bias from correlated omitted variables. Although we obtain higher R-squareds in the long-window models, the tenor of our results is essentially unaltered by the choice of the cumulation period. However, consis- tent with our earlier analysis, we find that the explanatory power under the returns specification also declines substantially from 1992 to 1993. In summary, the evidence from the returns model complements the other specifications, suggesting value relevance for the fair value disclosures.

5.3. Relation to extant research on value relevance o f fair value disclosures

Barth, Beaver, and Landsman (1995) and Nelson (1996) also examine the value relevance of SFAS 107 disclosures for banks. Using both a levels and a first- difference specification, BBL find that the excess of fair value over book value of securities, net loans, and long-term debt explain cross-sectional variations in firm value. Although there are differences in the significance of fair value variables across specifications, their results are largely consistent with our empirical findings.

In contrast, Nelson (1996) does not find consistent evidence for the value relevance of fair value disclosures. Using a market-to-book specification and without controlling for omitted variables, she finds statistical significance solely for the fair value of securities and only in 1992. However, when using a returns specification, Nelson (1996) finds that none of the fair value variables is asso- ciated with stock returns.

Our study differs from Nelson (1996) along several dimensions such as sample size, definition of independent variables, and choice of control variables. How- ever, in the specification of the returns model, the two studies differ only with respect to the measurement of the independent variables. While we incorporate the levels of the excess of fair over book values as explanatory variables, Nelson (1996) considers the changes in the difference between fair and book values. In Section 5.2, we highlight some plausible reasons offered in the extant literature for the superiority of the levels over the changes specification. Recall that, unlike Nelson (1996), we find strong support for the value relevance of fair value disclosures in our returns model. This suggests that the lack of significance for the returns model in Nelson (1996) could be related to the potential limitations of the changes specification noted earlier. 35 While we do not suggest that the

35 We replicate Nelson's (1996) change specification using our sample firms. Although these results are substantially weaker than those reported in Table 7, we do find significance for long-term debt at the 0.03 level and off-balance-sheet fair values at the 0.11 level (with correct signs). None of the other fair value variables is significant. However, in the subsample of large firms, we find that net loans, deposits, and off-balance-sheet instruments are all statistically significant at the 0.05 level with correct signs.

114 E.A. Eccher et al. / Journal o f Accounting and Economics 22 (1996) 79 117

changes specification is necessarily inferior, the results obtained in our study (and in BBL) using different specifications seem to suggest that the fair value disclosures are value-relevant. The choice among the different specifications considered in our study is worthy of further research.

6. Concluding remarks

Using a comprehensive sample of U.S. banks, this paper investigates empiric- ally the value relevance of fair value disclosures for financial instruments required by SFAS 107. We define value relevance in terms of the extent to which these supplementary disclosures are associated with share prices. Our results indicate that fair value estimates for securities, net loans, long-term debt, and market-related off-balance-sheet instruments are value-relevant either across our full sample or within a size-based subsample in one or more of our regression specifications. The finding for securities is consistent with previous work (Barth, 1994). The results for net loans suggest that although measurement error in these (generally) nontraded assets is greater than for marketable secur- ities, it is not as severe as critics have feared.

Our augmented model to examine the incremental value relevance of SFAS 107 disclosures involves including historical cost variables from a benchmark model which explains almost half of the variation in MB in the estimation years (1989 to 1991). Augmenting this base model with the fair value variables, we find that several of the latter continue to have significant explanatory power in 1992, but not in 1993.

To test the robustness of our results, we examine two alternative regression specifications, an undeflated levels model and a returns model. The results using undeflated levels are similar to those from the market - to-book regressions. The returns specification yields somewhat stronger results for all the fair value variables.

Taken together, our results suggest that the disclosures required under SFAS 105 and SFAS 107 have made GAAP financial statements a more comprehen- sive source of value-relevant information. The results of our incremental analyses, however, also suggest that historical cost variables provide more value-relevant information compared to fair value disclosures in both an abso- lute and an incremental sense. In 1992, the fair values alone explain 17% of the variation in the market - to-book ratio, which increases to 28% when the no- tional values are added to the model. However, the adjusted R-squared jumps to 63% when we include the historical cost financial ratios also. Similar compara- tive results are observed for 1993 as well. Since switching to a fair value accounting system could eliminate some value-relevant historical cost informa- tion, these findings should be germane for regulators who are evaluating alternative accounting regimes for banks (see Bernard et al., 1995).

E.A. Eccher et al. / Journal o f Accounting and Economics 22 (1996) 79 117 115

T h e d e t e r i o r a t i o n of s igni f icance in the fair va lue d i sc losures for 1993 is

n o t e w o r t h y a n d cons i s t en t b o t h in o u r s tudy a n d in BBL. F u t u r e r e sea rch

s h o u l d e x a m i n e r ea sons for this decl ine.

F ina l ly , it s h o u l d be n o t e d tha t the s a m p l e years for wh ich d a t a is ava i l ab le

were b o t h c h a r a c t e r i z e d by h i s to r i ca l ly l ow in teres t ra te levels, a fac to r wh ich is

ref lected in the p r e v a l e n c e of fair va lue e s t ima te s tha t exceed r e c o r d e d b o o k

values. T h e p r o p o n e n t s o f fair va lue (or m a r k - t o - m a r k e t ) a c c o u n t i n g are m o r e

c o n c e r n e d a b o u t the o p p o s i t e s cena r io w h e n fair va lues tha t fall b e l o w h i s to r ica l

cos ts cou ld serve as an ear ly s ignal of p o t e n t i a l b a n k so lvency p rob lems . It is

c o n c e i v a b l e for fair va lue d i sc losures in such a se t t ing to have dif ferent impl i ca -

t ions for b a n k s ' equ i ty va lues t h a n in the cu r r en t e n v i r o n m e n t . Th is hypo the s i s

can be tes ted as in te res t ra tes c h a n g e in the future.

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