Risk assessment for banks: Evidence from fair value accounting and supplemental disclosures

This study investigates the joint association of recognized and disclosed accounting information and measures of equity risk for banks. Specifically, it investigates the association between risk relevant accounting and regulatory information and four measures of equity risk: total equity risk, systematic market risk, systematic interest rate risk and cost of equity capital.;Previous research confirms that earnings variability and financial leverage are associated with equity risk. Although these variables are significant in explaining variation in equity risk, they do not explain all the cross-sectional variation in equity risk. Using data from annual reports, 10Ks, and Federal Reserve FY9-C reports, this study confirms that supplemental disclosures about market and credit risks are incrementally informative over earnings variability and financial leverage in explaining variation in measures of equity risk. Consistent with the multi-attribute nature of equity risk, this study documents that the joint association between recognized and disclosed accounting information and equity risk varies across measures of equity risk. Interestingly, this study also identifies accounting risk measures for banks that are associated with cost of equity capital, the equity risk measure that has received very little (but increasing) attention in accounting research.;Despite the theoretical advantages of fair value accounting, test results suggest that fair value earnings variability and financial leverage are not incrementally informative over book value earnings variability and financial leverage for banks in general. However, evidence is provided that fair values may be risk-relevant in particular settings based on bank type and loan portfolio composition. Using loan portfolio composition as a proxy for managerial discretion, this study provides evidence that managerial discretion affects the risk-relevance of credit risk disclosures for banks. The results from this study suggest that in addition to earnings variability and financial leverage, other firm-risk and industry-risk characteristics should be incorporated in equity risk assessment.