Review of Quantitative Finance and Accounting, 20: 355–384, 2003
2003 Kluwer Academic Publishers. Manufactured in The Netherlands.
Reliability of Banks’ Fair Value Disclosure for Loans
604 Uris Hall, Columbia Business School, New York, NY 10027, USA Tel.: 212 854-4249, Fax: 212 316-9219
Abstract. This study investigates whether banks manage the disclosed fair value of their major asset, the loan
portfolio. Using two cross-section samples, I ﬁnd evidence that suggests banks manage the fair value of loans.
The estimated extent of overstatement of loans’ fair value is negatively related to regulatory capital, asset growth,
liquidity and the gross book value of loans, and positively related to the change in the rate of credit losses. These
relations imply that some banks overstate the disclosed fair value of loans in an attempt to favorably affect the
market assessment of their risk and performance.
Key words: fair value, ﬁnancial instruments, loans, banks, disclosure management
JEL Classiﬁcation: M41, G21, G12
Fair value is increasingly being recommended by regulators and users of ﬁnancial infor-
mation as a basis of accounting measurement.
One criticism of the use of fair values is
their potential unreliability when there are no market prices for the asset or liability. In
this study, I investigate whether banks manage the reported fair value of loans, and, if so,
what determines the extent of overstatement.
I hypothesize that management’s incentives
to overstate the fair value of loans are positively related to the bank’s risk and negatively
related to the bank’s performance. I then construct proxies for risk, performance and the
bank’s ability to manage the fair value of loans, and test whether these proxies explain
cross-sectional differences in the reported fair values.
The reported fair value is supposed to represent the intrinsic (“true”) value of loans,
which in turn is likely to be correlated with the bank’s incentives to manage the fair value.
Therefore, when explaining the reported fair value of loans, it is important to control for
their intrinsic value. However, the intrinsic value of loans is unobservable. I thus use a latent
variable technique that extracts information about the intrinsic value of loans from: (1) the
gross book value of loans, (2) the market value of equity, (3) the effective interest rate on
the loan portfolio, and (4) measures of the loans’ credit quality.
I focus on the fair value of loans because banks’ ability to manage this estimate is
greater than their ability to manage the fair value of most other ﬁnancial instruments. This
ability results from the lack of availability of quoted market prices for most loans and
from their long-term nature. Also, for banks, loans constitute a high proportion of total
assets, augmenting both the importance of the research question and the power of the tests.
Finally, banks provide relatively detailed and uniform information about their loan portfolios