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Discussion of Carey and Barth, Landsman, and Wahlen
Journalof BANKING & ELSEVIER
Journalof Banking & Finance 19 (1995) 623-625
FINANCE
Discussion of Carey and Barth, Landsman, and Wahlen Anne Beatty The Wharton School o[ the University of Pennsyloania, Financial Institutions Center, 3303 Steinberg Hall-Dietrich Hall, Philadelphia, PA 19104-6367, USA
E a c h of these papers examines a different issue related to the likely effect on banks of the adoption of fair value accounting for investment securities. Carey focuses on the impact on regulatory discipline, while Barth, Landsman, and Wahlen examine investors reaction to fair value information. Carey highlights that the interpretation of a null result from his estimated failure prediction model is ambiguous, because the model provides a joint test of the three conditions required for regulatory discipline to improve as a result of a change to fair value accounting. He explains that unrealized gains and losses may not predict failure, either because they are not an important part of economic capital, or because they are used by regulators to determine the proper action to prevent failure. However, this ambiguity in interpretation may not be restricted to a null result. Carey's interpretation of the importance of unrealized securities gains and losses in predicting failure assumes that this relationship will hold only if these variables are determinants of economic capital. Although this may be true for ultimate failure, the dependent variable is failure within the next two years. If regulators respond only to reported numbers and the capital rules currently in effect, then net gains may be used to increase reported capital and to avoid short run insolvency, even ff the bank will ultimately fail. Therefore a significant coefficient on the unrealized gains may be found in the estimated failure prediction model, even if these unrealized gains are unrelated to economic capital. A second potential ambiguity arises in the interpretation of the relative magnitude of the coefficients on net unrealized gains versus net unrealized losses as a measure of the difference in regulatory response to gains versus losses. The coefficients on these variables measure the probability of failure for banks with net 0378-4266/95/$09.50 © 1995 ElsevierScienceB.V. All rights reserved SSDI 0378-4266(94)00143-X
624
A. Beatty/Journal of Banking & Finance 19 (1995) 623-625
gains versus banks with net losses rather than the differential effect on the probability of failure of gains versus losses. Carey includes annual dummy variables to control for the correlation of the existence of gains versus losses with changes in interest rates; however, there may also be other differences in characteristics for banks with net gains versus those with net losses that may explain the difference in the probability of failure. Finally, Carey's analysis of whether economic capital reflects the difference between fair value and book value of investment securities is complicated by the effect of this difference on regulatory action. As Carey notes, without a direct test of the importance of unrealized securities gains and losses on regulatory action it is difficult to draw conclusions about whether economic capital reflects the difference between fair value and book value of investment securities. Barth, Landsman, and Wahlen examine bankers' concern that investors would price the increased volatility in reported earnings and capital due to fair value accounting even though it is not indicative of true risk. This argument assumes that investors only use financial statement information and that they ignore other disclosures. The proponents of fair value accounting believe that the increase in reported volatility reflects true risk, but agree that disclosure is not adequate to ensure that information will be incorporated into investors decisions. They find no evidence that investors currently price the volatility associated with fair value accounting for investments, and conclude that the bankers concerns are unfounded. The assumption of no change in investor behavior when disclosed information is included in the financial statements, which is implicit in their conclusion, is contrary to the assumptions made by both the opponents and proponents of fair value accounting. The evidence reported by Barth, Landsman and Wahlen is consistent with both positions, since both argue that investors will not react to disclosed information. However, if investors accurately incorporate all information, then the evidence supports the bankers' assertions that the reported volatility is not indicative of the true volatility of the bank. Similarly, if regulators were not adjusting financial statement numbers for differences between the fair value and book value of investment securities, then their finding that share prices did not reflect capital violations that would have occurred under fair value accounting cannot be used to predict the effects of this accounting change. Barth, Landsman, and Wahlen regress stock price on earnings and a multiplicative term of earnings and the standard deviation of earnings under both historical cost and fair value accounting to determine whether banks' cost of capital reflects earnings variability caused by changes in the value of investment securities. To justify this specification, they appeal to a certainty equivalent pricing model and to an earnings response coefficient model. They estimate this regression assuming constant coefficients across all firms and all periods. The coefficient on earnings will be constant only if the risk free rate is constant over the 1970-1990 period, while the coefficients on the multiplicative terms will be constant only if the correlation of the standard deviation of earnings with the market is constant across
A. Beatty /Journal of Banking & Finance 19 (1995) 623-625
625
firms. If these assumptions do not hold, then the model will be misspecified. Misspecification is particularly important in their tests for differences in coefficients across the variance measures, since the effect of the misspecification on the estimated coefficients may not be the same for the two variance measures. In that case the difference in the estimated coefficients for the variability of historical cost earnings and fair value earnings may be caused by the model misspecification rather than to a difference in how investors price these two types of earnings variability.
Journalof Banking & Finance 19 (1995) 623-625
FINANCE
Discussion of Carey and Barth, Landsman, and Wahlen Anne Beatty The Wharton School o[ the University of Pennsyloania, Financial Institutions Center, 3303 Steinberg Hall-Dietrich Hall, Philadelphia, PA 19104-6367, USA
E a c h of these papers examines a different issue related to the likely effect on banks of the adoption of fair value accounting for investment securities. Carey focuses on the impact on regulatory discipline, while Barth, Landsman, and Wahlen examine investors reaction to fair value information. Carey highlights that the interpretation of a null result from his estimated failure prediction model is ambiguous, because the model provides a joint test of the three conditions required for regulatory discipline to improve as a result of a change to fair value accounting. He explains that unrealized gains and losses may not predict failure, either because they are not an important part of economic capital, or because they are used by regulators to determine the proper action to prevent failure. However, this ambiguity in interpretation may not be restricted to a null result. Carey's interpretation of the importance of unrealized securities gains and losses in predicting failure assumes that this relationship will hold only if these variables are determinants of economic capital. Although this may be true for ultimate failure, the dependent variable is failure within the next two years. If regulators respond only to reported numbers and the capital rules currently in effect, then net gains may be used to increase reported capital and to avoid short run insolvency, even ff the bank will ultimately fail. Therefore a significant coefficient on the unrealized gains may be found in the estimated failure prediction model, even if these unrealized gains are unrelated to economic capital. A second potential ambiguity arises in the interpretation of the relative magnitude of the coefficients on net unrealized gains versus net unrealized losses as a measure of the difference in regulatory response to gains versus losses. The coefficients on these variables measure the probability of failure for banks with net 0378-4266/95/$09.50 © 1995 ElsevierScienceB.V. All rights reserved SSDI 0378-4266(94)00143-X
624
A. Beatty/Journal of Banking & Finance 19 (1995) 623-625
gains versus banks with net losses rather than the differential effect on the probability of failure of gains versus losses. Carey includes annual dummy variables to control for the correlation of the existence of gains versus losses with changes in interest rates; however, there may also be other differences in characteristics for banks with net gains versus those with net losses that may explain the difference in the probability of failure. Finally, Carey's analysis of whether economic capital reflects the difference between fair value and book value of investment securities is complicated by the effect of this difference on regulatory action. As Carey notes, without a direct test of the importance of unrealized securities gains and losses on regulatory action it is difficult to draw conclusions about whether economic capital reflects the difference between fair value and book value of investment securities. Barth, Landsman, and Wahlen examine bankers' concern that investors would price the increased volatility in reported earnings and capital due to fair value accounting even though it is not indicative of true risk. This argument assumes that investors only use financial statement information and that they ignore other disclosures. The proponents of fair value accounting believe that the increase in reported volatility reflects true risk, but agree that disclosure is not adequate to ensure that information will be incorporated into investors decisions. They find no evidence that investors currently price the volatility associated with fair value accounting for investments, and conclude that the bankers concerns are unfounded. The assumption of no change in investor behavior when disclosed information is included in the financial statements, which is implicit in their conclusion, is contrary to the assumptions made by both the opponents and proponents of fair value accounting. The evidence reported by Barth, Landsman and Wahlen is consistent with both positions, since both argue that investors will not react to disclosed information. However, if investors accurately incorporate all information, then the evidence supports the bankers' assertions that the reported volatility is not indicative of the true volatility of the bank. Similarly, if regulators were not adjusting financial statement numbers for differences between the fair value and book value of investment securities, then their finding that share prices did not reflect capital violations that would have occurred under fair value accounting cannot be used to predict the effects of this accounting change. Barth, Landsman, and Wahlen regress stock price on earnings and a multiplicative term of earnings and the standard deviation of earnings under both historical cost and fair value accounting to determine whether banks' cost of capital reflects earnings variability caused by changes in the value of investment securities. To justify this specification, they appeal to a certainty equivalent pricing model and to an earnings response coefficient model. They estimate this regression assuming constant coefficients across all firms and all periods. The coefficient on earnings will be constant only if the risk free rate is constant over the 1970-1990 period, while the coefficients on the multiplicative terms will be constant only if the correlation of the standard deviation of earnings with the market is constant across
A. Beatty /Journal of Banking & Finance 19 (1995) 623-625
625
firms. If these assumptions do not hold, then the model will be misspecified. Misspecification is particularly important in their tests for differences in coefficients across the variance measures, since the effect of the misspecification on the estimated coefficients may not be the same for the two variance measures. In that case the difference in the estimated coefficients for the variability of historical cost earnings and fair value earnings may be caused by the model misspecification rather than to a difference in how investors price these two types of earnings variability.