Gauri Bhat

Credit Risk and IFRS: The Case of Credit Default Swaps

This study compares the pricing of credit risk information conveyed by accounting numbers under IFRS relative to local GAAP. We measure the price of credit risk by CDS spreads and focus on three fundamental accounting metrics that inform about credit risk: earnings, leverage and book value equity. Using a difference in differences methodology, we find that while earnings, book value and, to a lesser extent, leverage are significant determinants of credit risk pricing both prior to and after IFRS adoption, the adoption of IFRS did not change the credit risk informativeness of these accounting variables as reflected in CDS spreads. This conclusion is robust to controlling for institutional differences among countries as well as a battery of sensitivity analyses.

Impact of Disclosure and Corporate Governance on the Association Between Fair Value Gains and Losses and Stock Returns in the Commercial Banking Industry

In this paper, I examine the relations between risk management disclosures, governance, and the market pricing of the fair value gains and losses (FVGL) for US commercial bank holding companies (banks). I find that banks with strong corporate governance disclose more about their risk management practices and that the market pricing of the FVGL increases with the level of disclosure. The disclosure’s effect on the market pricing of the FVGL is more pronounced for banks during periods of crisis, for banks with risky assets, and for banks with poor performance. Further analysis shows that subcategories of disclosure have different roles to play under different risk conditions. Overall, the evidence in this paper suggests that market participants perceive the FVGL of banks with high disclosure and strong corporate governance as more relevant and reliable. One potential interpretation is that disclosure aids market participants in evaluating the quality of the FVGL.

Credit Risk and IFRS

This study compares the pricing of credit risk information conveyed by accounting numbers under International Financial Reporting Standards (IFRS) relative to local Generally Accepted Accounting Principles (GAAP). We measure the price of credit risk by credit default swap (CDS) spreads and focus on three fundamental accounting metrics that inform about credit risk: earnings, leverage, and book value equity. Using a difference-in-differences methodology, we find that while earnings, book value, and, to a lesser extent, leverage are significant determinants of credit risk pricing both prior to and after IFRS adoption, the adoption of IFRS did not change the credit risk informativeness of these accounting variables as reflected in CDS spreads. This conclusion is robust to controlling for institutional differences among countries as well as a battery of sensitivity analyses.

Using Loan Loss Indicators by Loan Type to Sharpen the Evaluation of Banks’ Loan Loss Accruals

We provide evidence that the determinants of the primary loan loss indicators reported in financial reports — non-performing loans, the allowance and provision for loan losses, and net loan charge-offs — vary dramatically across real estate, commercial, and consumer loans, because these loan types differ in their homogeneity and collateralization and thus in the measurement of incurred losses under GAAP. Extending Wahlen (1994), we develop and estimate models of the non-discretionary and discretionary determinants of these loan loss indicators by loan type. The estimations indicate that banks’ exercise of discretion over provisions for loan losses is largely limited to heterogeneous commercial loans, a small slice of banks’ loan portfolios, and they provide many insights into the bank-specific and macroeconomic drivers of banks’ loan loss accruals. To demonstrate the increased statistical power and construct validity that results from conducting research on banks’ loan loss accruals by loan type, we show that this approach significantly improves the accuracy of out-of-sample predictions of future net loan charge-offs, more so for samples of banks whose loan portfolio composition varies more from that of the average bank. Our results illustrate the usefulness of disaggregated disclosures of loan loss indicators by loan type for future accounting research.

Risk Relevance of Fair Value Gains and Losses, and the Impact of Disclosure and Corporate Governance

This study uses variance decomposition analysis to examine the variance contribution of fair value gains and losses (FVGL) relative to net income (NI) in driving security returns for a sample of 180 US commercial banks for the period 2001-2005. I document that FVGL are significant in explaining the volatility of unexpected returns and that the relative importance of FVGL to NI is an increasing function of disclosure and corporate governance. While the effect of disclosure is direct, the effect of corporate governance is indirect and comes via disclosures. Further, I classify disclosures by type of risk and find that the relative variance contribution of FVGL increases with the level of disclosure related to interest rate risk, credit risk and derivatives risk for banks that are exposed to these risks. Overall, the results suggest that FVGL are risk relevant; and that disclosure and corporate governance aid investors in evaluating the risk revelation attributes of fair value estimates.

Testing the Transparency Implications of Mandatory IFRS Adoption: The Spread/Maturity Relation of Credit Default Swaps

This study tests whether IFRS adoption increased accounting transparency based on model-driven hypotheses. Duffie and Lando (2001) show that changes to accounting transparency affect the spread/maturity relation of CDS instruments in very specific ways. Consistent with their model, we find that CDS spreads are lower across maturities following the adoption of IFRS, and the slope and concavity of the CDS spread/maturity relation are higher. These changes did not occur to the spread/maturity relation of a control sample of CDS instruments. Predicted changes apply more intensely to firms with low pre-IFRS transparency. Overall, this study provides strong evidence that IFRS adoption increased accounting transparency.

Bank Capital Structure and Loan Monitoring

This paper empirically examines the association between bank capital and banks’ monitoring effort. We use four proxies to measure the unobservable monitoring effort. Two of the proxies are based on loan quality (ex-post outcomes of monitoring effort). The other two proxies are based on salary expense (ex-ante proxies intended to capture the quality and quantity of labor input into monitoring effort). Using a bank and time fixed effects estimation, we find a positive association between bank capital and each of our measures of monitoring effort. We find that this association is more pronounced for smaller banks and banks that engage in higher levels of relationship lending. Numerous additional tests and robustness checks including matched sample analysis and instrumental variable approach to address endogeneity confirm our main findings. Overall, our evidence is consistent with the prediction in Mehran and Thakor (2011) that banks that keep higher capital monitor more.

Bank Capital and Loan Monitoring

This paper empirically examines the association between bank capital and banks’ monitoring effort. We use four proxies to measure the unobservable monitoring effort. Two of the proxies are based on loan quality (ex-post outcomes of monitoring effort). The other two proxies are based on salary expense (ex-ante proxies intended to capture the quality and quantity of labor input into monitoring effort). Using a bank and time fixed effects estimation, we find a positive association between bank capital and each of our measures of monitoring effort. We find that this association is more pronounced for smaller banks and banks that engage in higher levels of relationship lending. Numerous additional tests and robustness checks including matched sample analysis and instrumental variable approach to address endogeneity confirm our main findings. Overall, our evidence is consistent with the prediction in Mehran and Thakor (2011) that banks that keep higher capital monitor more.

Bank Capital and Monitoring: Evidence from Loan Quality

This paper empirically examines the association between bank capital and banks’ monitoring effort. We use four proxies to measure the unobservable monitoring effort. Two of the proxies are based on loan quality (ex-post outcomes of monitoring effort). The other two proxies are based on salary expense (ex-ante proxies intended to capture the quality and quantity of labor input into monitoring effort). Using a bank and time fixed effects estimation, we find a positive association between bank capital and each of our measures of monitoring effort. We find that this association is more pronounced for smaller banks and banks that engage in higher levels of relationship lending. Numerous additional tests and robustness checks including matched sample analysis and instrumental variable approach to address endogeneity confirm our main findings. Overall, our evidence is consistent with the prediction in Mehran and Thakor (2011) that banks that keep higher capital monitor more.

The Relation between Bank Credit-Risk Management Procedures and Originate-to-Distribute Mortgage Quality During the Financial Crisis

We examine the relation between bank risk-assessment procedures and sales of mortgages before and after the first quarter of 2007. Research (Purnanandam [2010]) suggests that banks employing an originate-to-distribute (OTD) strategy devoted little effort to screening thereby diminishing their ability to sell loans during the crisis. We use 10-K disclosures of credit-risk assessment procedures to measure the extent of a bank’s internal screening and risk-management procedures. We find banks with higher scores (i.e., stronger risk management) were better able to sell mortgages during the financial crisis and had fewer non-performing mortgage loans than banks with lower scores. In addition, we find higher scores attenuate the positive association between a bank’s use of more mechanical screening techniques and its involvement in the OTD market documented by Purnanandam [2010]. Thus, enhanced credit-risk management procedures seem to mitigate incentives to substitute mechanical screening models for the collection of costly information when banks more zealously employ an OTD strategy. Taken together, these results imply that mortgage purchasers were aware of cross-sectional differences and suggest that mechanisms exist for banks to credibly distinguish the quality of their loans despite incentives problems associated with the OTD business model.