The Relevance/Reliability Impact the Financial Crisis and SFAS 161 Had on the Use and Reporting of Derivatives within the Banking Industry

Opinions on how the use of derivatives affects a firms’ value vary from critical to complimentary. Just prior to the events studied in this paper, renowned investor Warren Buffet referred to the use of derivatives as “time bombs”. During the same period, Alan Greenspan, then Chairman of the Federal Reserve Board, stated that the use of derivatives played a key role in the reduction of financial risk. The complexities related to these financial instruments lead to such diverse opinions. Because these opinions are subjective, they are susceptible to change when influential events transpire. This paper investigates how the 2008 Financial Crisis, combined with the promulgation of SFAS 161, affected the value relevance of notional amounts of derivatives within the banking industry. Did the 2008 Financial Crisis and the role derivatives played exacerbate investor’s negative views on the use of derivatives? Perhaps, this event stressed the importance of properly hedging through derivatives, thus increasing markets positive perception of their use. SFAS 161 required the data be organized in a much friendlier format and re-introduced the requirement that notional amounts of derivatives be presented in the notes. Thus, SFAS 161 may have positively affected the reliability of the data and, in turn, the relevance such information has on the valuation of a firm. In order to better, ascertain the effects of these events; this paper categorizes derivatives into two general categories, risk management and trading; while banks are classified as nonmarket makers and market makers. The study finds that, for nonmarket makers, risk management derivatives are not value relevant during the precrisis/SFAF 161 periods but subsequently become value relevant. The study also finds that, for market makers, risk management derivatives are value relevant during the pre-crisis period and subsequently become insignificant. Trading derivatives are insignificant for both bank classifications; though their incremental weight in valuation increased significantly during the post period for market makers. Overall, these results suggest that the relationship between derivatives and share prices was differentially affected by these events based on derivative and bank classification. More specifically, results show that risk management derivatives are given higher relevance as risk reducers for traditional banks after the events. These results are consistent with the notion that the events studied increased the markets perception of derivatives as risk reducers for traditional banks. These same events, however, had the opposite effect for market making banks; making risk management derivatives insignificant for these banks and increasing the relevance of the positive relationship of trading derivatives and share price during the post period. These last results are consistent with the notion that market making banks benefit from an “implied bailout”, making risk management derivatives less important for these banks and trading derivatives less risky. Keyword: Derivatives, Bank Holding Companies, SFAS 161, Financial Crisis. Academy of Accounting and Financial Studies Journal Volume 22, Issue 1, 2018 2 1528-2635-22-1-125 INTRODUCTION This paper investigates the impact the 2008 Financial Crisis and contemporaneous disclosure requirements, under SFAS 161, had on the value relevance of the notional amounts of derivatives. In particular, the paper examines the association between changes in notional amounts of derivatives and changes in share prices within the banking industry and compares how this association has changed during the periods before and after these events. Derivatives are classified by general purpose, risk management vs. trading and bank holding companies (BHC) by market making and nonmarket making banks in an effort to identify differential effects the events may have had within each category. The research questions addressed are important for a number of reasons. First, the use of derivatives has increased dramatically over the past several years, while research on the relevance of notional amounts has remained stagnant. During the time period sampled in this study, the total notional amount of derivative contracts held by the top 25 BHCs increased fivefold from $48.1 trillion dollars in the first quarter of 2002 to $236.6 trillion dollars in the last quarter of 2015. Investors have diverse opinions on the benefits of derivatives. For example, in 2002 and 2003, respectively, in his annual letters to shareholders, Warren Buffet, Chairman of Berkshire Hathaway Inc., referred to derivatives as time bombs and financial weapons of mass destruction (Berkshire Hathaway Inc. Shareholder Letters 2002, 2003). Meanwhile, in May of 2005, Alan Greenspan, then Chairman of the Federal Reserve Board, stated that the use of derivatives were key factors underpinning the resilience of our large banking institutions which permitted the unbundling of financial risks (FRB, Forty-First Annual Conference on Bank Structures, 2005). These diverse opinions are reflective of the contradicting views market participants have on derivatives. Because the use of derivatives has increased so dramatically in recent years, opinions are so diverse and historical accounts of their benefits and detriments are confounding, it is imperative to re-examine their association with firm value after potential influential events have transpired and to understand how they relate to prior associations. Second, the banking industry has undergone major structural and regulatory changes in recent years. Investment banks such as Morgan Stanley, Goldman Sachs, Merrill Lynch and Bear Stearns either became or were merged into a BHC during the Financial Crisis. This has increased the heterogeneity within this industry. Though prior research in the banking industry has generally distinguished between large and small banks, research examining the value relevance of notional amounts derivatives has not made such distinctions. This study considers two contemporaneous events that transpired during 2008 and 2009 hypothesized to affect the markets perception of the relevance and reliability of derivative instruments and related reporting, respectively. The first event considered is the 2008 Financial Crisis. This crisis, which began mid-year 2007 and culminated at the end of 2008, resulted in the collapse of some of the most reputable financial institutions. The effects of the crisis were not limited to the banking industry; almost all industries were adversely affected by the crisis. Much has been written about the crisis by regulators, academicians and others in an effort to offer insight on the causes and remedies. Research on the causes of the crisis usually includes an examination of the role derivatives played. Kothari and Lester (2012) find that the rising popularity of derivative instruments contributed to the advent of the 2008 financial crisis. Barth and Landsman (2010) examine four areas, which may have potentially played a role in the crisis: Fair values, asset securitization, derivatives and loan loss provisions. While they do not precisely define the role derivatives played in the markets as overall positive or negative, they recommend Academy of Accounting and Financial Studies Journal Volume 22, Issue 1, 2018 3 1528-2635-22-1-125 more disaggregated information and increased transparency in the disclosures; an area directly related to the second event considered. The second event considered is the pronouncement of SFAS No. 161 disclosures about Derivative Instruments and Hedging Activities effective beginning in 2009. An often overlooked fact was that SFAS No. 133 did not carry forward SFAS No. 119 requirement for disclosures of notional amounts of derivatives because the FASB believed then that the enhanced disclosures of SFAS No. 133 would obviate their need. Notional amounts give market participants an idea of the extent of involvement in derivatives (FASB 1990). Notional amounts are not actually exchanged between parties, but they are an integral part in the computational formula used to determine the periodic cash flows that are paid or received during the life of the contract (Seow and Tam 2002). SFAS No. 161 not only re-introduced the requirement that such disclosures on notional amounts of derivatives be presented in the notes to the statements but also required that the information be presented in a simple to follow tabular format (Exhibit 1). While this information may have been available through other sources, the markets perception of reliability may differ by source. Ahmed et al. (2006) find that recognized derivative fair values are value relevant while similar disclosed fair values are not. They pose two possible explanations for this, the “limited attention” and “costly information processing models” or perceived higher standards required by auditors for recognized items versus those disclosed. In similar fashion, the new tables required by SFAS 161 may help investors overcome the “costly information processing”. While SFAS 161 does not make any changes between recognized and disclosed information, the new tables make the information much easier to reconcile and track with recognized data. This may cause management and auditors to impose higher standards of reliability in similar fashion to recognized data. Auditing enhances the credibility of financial statement information (Kohlbeck 2008) and these new tables incentivize the auditor to perform enhanced auditing techniques, bringing them closer to the reliability spectrum of recognized financial data. In summary, SFAS 161 reintroduced the requirement to explicitly disclose notional amounts of derivatives and made derivative information, in general, easier to read and interpret; factors this study hypothesizes have led to greater information reliability. Risk management derivatives serve to reduce risk within a firm by off