Banks’ Discretion Over the Debt Valuation Adjustment for Own Credit Risk

Abstract

During our 2007 to 2015 sample period, firms recorded unrealized gains and losses on fair-valued liabilities attributable to changes in the firms’ own credit risk, referred to as the debt valuation adjustment (DVA), in earnings. Various parties criticized the inclusion of DVA in earnings as counterintuitive and manipulable. Using a small but comprehensive sample of European banks reporting nonzero DVA during this period, we decompose banks’ DVA into a normal portion explained by economic factors (e.g., changes in bond yield spreads) and an abnormal portion (the residual). Controlling for abnormal loan loss provisions (LLP) and realized securities gains and losses (RGL), we find that banks’ abnormal DVA is negatively associated with their premanaged earnings, consistent with banks exercising discretion over DVA to smooth earnings. We further find that banks that record larger LLP or RGL or that have histories of using LLP or RGL to smooth earnings are less likely to exercise discretion over DVA. These findings obtain in the financial crisis but not afterward. Collectively, our findings suggest that banks exercised discretion over DVA substitutably with discretion over LLP and RGL during the crisis. With the caveat that our analysis is limited by a small sample and the inherent difficulties of DVA decomposition, our findings have implications for how bank regulators and investors should interpret banks’ reported DVA, particularly in stress periods such as the crisis, and they provide support for the International Accounting Standards Board and Financial Accounting Standards Board’s (FASB) decisions to require firms to record DVA in other comprehensive income starting in 2018.