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


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Banks' Discretion over the Debt Valuation Adjustment for Own Credit Risk
Dong M., Doukakis L.C., Ryan S.G.
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Banks that recognize financial liabilities at fair value currently must record unrealized gains (losses) on these liabilities attributable to increases (decreases) in the banks’ own credit risk, referred to as the debt (or debit) valuation adjustment (DVA), in earnings each period. For a sample of publicly traded European banks during 2008-2013, we investigate the economic and discretionary determinants of DVA. We find that DVA exhibits the expected associations with economic factors, being positively associated with the change in banks’ bond yield spread and negatively associated with the changes in banks’ unsecured debt and average remaining bond maturity. We also provide evidence that banks exercised discretion over DVA to smooth earnings during the recent financial crisis and its immediate aftermath. To remove non-discretionary smoothing of earnings, we decompose DVA into nondiscretionary (normal) and discretionary (abnormal) components and find that abnormal DVA is negatively associated with pre-managed earnings, controlling for banks’ abnormal loan loss provisions (LLP) and realized securities gains and losses (RGL), consistent with banks exercising discretion over DVA to smooth earnings. We further find that banks that record larger LLP and that have histories of using LLP to smooth earnings use DVA less to smooth earnings, consistent with LLP and DVA being substitutable ways to smooth earnings. These findings have implications for how bank regulators and investors should interpret banks’ reported DVA. They may support the FASB’s recent decision in ASU 2016-1 to require firms to record DVA in other comprehensive income.
Debt valuation adjustment, DVA, Own credit risk, Fair value option for liabilities, Income smoothing
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06/09/2016 8:55
Last modification date
21/08/2019 5:13
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