The impact of FAS 133, accounting for derivatives and hedging, on financial institution returns.

Thapa, Samanta B. ; Brown, Christopher L.

INTRODUCTION

It is well recognized that derivative instruments (if properly used) are effective risk management tools. Some companies, however, have misused these instruments exposing them to potential financial ruin. Until recently, accounting standards did not require banks to report derivatives use and their impact on earnings on their financial statements. Some financial institutions had positions in derivatives that could significantly impact their earnings. The Financial Accounting Standards Board (FASB) adopted a new rule (FAS 133) on June 1, 1998, which requires companies to put derivative financial instruments on the balance sheet as assets or liabilities measured at their fair market value and reflect the changes in value on their income statement. The underlying rationale for the adoption of this rule is to inform investors so that they can better grasp the impact of derivatives on a company's earnings. Smith, Waters and Wilson (1998) describe in detail the accounting requirements of FAS 133, its merits and potential concerns.

The purpose of this paper is to analyze the impact of the adoption of FAS 133 on the stocks of financial institutions. We are focusing on financial institutions because they are heavy users of derivatives. For example, banks use these derivative instruments routinely in their asset/liability management techniques to hedge against interest rate and foreign exchange risks. The new ruling will affect their asset/liability management techniques significantly.

FAS 133 AND ITS IMPLICATIONS

FAS 133 has been controversial. Proponents of the standard argue that investors have the right to know and understand the companies they invest in. Since derivatives are not included in the financial statements at present, millions of investors who are faced with investment decisions for retirement, down payments for homes, and children's education have no way of knowing if a bank is in a precarious financial position. The availability of information to investors will discourage banks from misusing these instruments for fear of an adverse stock price reaction. Opponents, on the other hand, argue that it is difficult to determine the fair market value of many of these instruments and companies may record distorted values on their financial statements. Further, this standard introduces tremendous earnings volatility. Many banks, who are heavy users of these instruments, have opposed FAS 133 on these grounds. Federal Reserve Chairman Alan Greenspan was also opposed to FAS 133 for the reasons cited above.

Boyd, Hayt, Reynolds and Smithson (1996) look at the comment letters received by the FASB on the Exposure Draft of the proposed changes in derivatives accounting. Forty-nine percent of the responses were from banks and the remaining from non-financial firms, academia, and the accounting profession. The majority of responses expressed dissatisfaction with the proposed statement.

The increase in use (and complexity) of derivative securities by companies has to be matched by the development of proper accounting techniques so that investors are fully informed. Accounting standards, however, have not kept pace with this change. FASB was aware of this situation for a long time and started to examine this problem as early as 1990. After a thorough study and exhaustive discussions, the FASB finally adopted a standard on derivatives and hedging on June 16, 1998 [FAS 133]. The compliance date initially was set for fiscal years beginning after June 15, 1999. Because of numerous complaints from companies, the compliance date was postponed to July 1, 2000 and again postponed to January 1, 2001, with earlier compliance encouraged. Important dates are shown in Table 1. The new standard requires companies to record derivatives on the balance sheet as assets or liabilities, measured at their fair market values. Companies also have to record any changes in the value of the derivatives as gains or losses on their income statements, unless the derivatives qualify as hedges.

LITERATURE REVIEW

The finance literature is replete with studies dealing with investors' reactions to the adoption of new accounting standards. Espahbodi, Strock, and Tehranian (1991) study the impact of SFAS No. 106 on equity prices. SFAS 106 requires companies to use the accrual method of accounting for nonpension postretirement benefits. The effect of this accounting change is to increase reported expenses, decrease reported net income and increase liabilities for firms that offer postretirement benefits. Espahbodi, Stock and Tehranian (1991) find a negative stock price reaction for the 143 sample firms associated with this expense increasing standard. They also find the negative stock price reaction is more pronounced for firms with higher debt ratios and smaller firms.

Khurana (1991) examines the stock price reaction of firms to the introduction of SFAS No. 94. SFAS 94 requires firms to consolidate all majority-owned subsidiaries, including foreign subsidiaries and subsidiaries with heterogeneous operations. One effect of this accounting change is that some financial statement components will be different than they were before this accounting standard was adopted. Khurana (1991) finds a negative stock price reaction to the issuance of SFAS No. 94 for the 72 companies in the sample.

Beatty, Chamberlain and Magliolo (1996) study the impact of the adoption of SFAS 115 on equity prices. SFAS 115 requires the use of fair value accounting for some categories of investment securities and requires that unrecognized gains and losses on these securities be accounted for on the balance sheet. The Beatty, Chamberlain and Magliolo (1996) sample consists of bank holding companies and insurance companies. They find a negative stock price reaction to events indicating SFAS 115 is likely to pass for bank holding companies, but find no reaction for the sample of insurance companies.

Aside from numerous newspaper and magazine articles, no rigorous econometrics investigation of the stock market reaction to FAS 133 has appeared in the literature so far. Since this standard is very important and has profound policy implications, this type of econometrics study is needed at this time.

DATA

The event examined in this investigation is the passage of the FAS 133 final standard. The final standard was passed on June 1, 1998. Our study focuses on the stock price reaction of commercial banks to the introduction of FAS 133. Therefore, our sample contains all commercial banks with publicly traded stock that are listed on the New York Stock Exchange, the American Stock Exchange, or NASDAQ. Another requirement is that trading information on the banks is available during the sample period. We are only interested in banks that have publicly traded stock because we are investigating the stock price reaction to the announcement of the FAS 133 final derivatives standard issued on June 16, 1998. Our final sample consists of 533 large commercial banks.

METHODOLOGY

Event study methodology is used to model stock price reactions. We employ a single factor market model using the following equation to calculate expected stock price returns:

[r.sub.jt] = [a.sub.j] + [b.sub.j][r.sub.mt] + [e.sub.jt], (1)

where

[r.sub.jt] = the return on security j for period t,

[a.sub.j] = the intercept term,

[b.sub.j] = the covariance of the returns on the jth security with those of the market portfolio's returns,

[r.sub.mt] = the return on the CRSP equally-weighted market portfolio for period t, and

[e.sub.jt] = the residual error term on security j for period t.

The parameters of the market model were estimated during a 255-day control period that began 271 days before the announcement date and ended 16 days before the announcement date. The announcement date (Day 0) is the date that the FASB final standard was passed. The market model parameters from the estimation period are used to estimate the expected returns for each day of the event period.

The event period begins 15 days (Day -15) before the announcement date and ends 15 days (Day 15) after the announcement date. The abnormal return ([ABR.sub.jt]) is the difference between the actual return and the expected return. It is calculated by subtracting the expected return (which uses the parameters of the firm from the estimation period and the actual market return for a particular date in the event period) from the actual return ([R.sub.jt]) on that date. The equation is as follows:

[ABR.sub.jt] = [R.sub.jt] - ([a.sub.j] + [b.sub.j][R.sub.mt]), (2)

where each of the parameters are as previously defined. The average abnormal return for a specific event date is the mean of all the individual firm abnormal returns for that date:

[AR.sub.t] = [N.summation over (j=1)] [ABR.sub.jt]/N (3)

where N is the number of firms used in calculation. The cumulative average return (CAR) for each interval is calculated as follows:

[MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII] (4)

We perform a Z-test to determine if the CARs are significantly nonzero. We use the cross-sectional test proposed by Boehmer, Musumeci and Poulson (1991).

FINDINGS AND CONCLUSIONS

The findings are reported in Table 2. The average abnormal return for the banks in the sample on the event date was -0.26% (significant at the .01 level). The cumulative abnormal returns (CARs) are also negative and statistically significant for the event windows (-1 to 0) and (-5, +5). The negative stock price reaction indicates that as far as commercial banks are concerned investors view this as a negative event. Investors seem to agree with the arguments made by the opponents of this standard; that it introduces volatility to reported earnings and that it is very difficult to measure fair market values of derivative instruments.

Another possible explanation of the negative stock price reaction is that investors know banks are heavy users of derivatives and are concerned that bank's stock prices will be hurt if they report derivatives activity. Banks use derivatives primarily for hedging, but some speculative trading in derivatives has occurred and has been widely reported in the popular press. Investors may be concerned that banks engaged in derivatives activities are engaged in risky behavior, even though the vast majority of banks that invest in derivatives do so to reduce risk.

REFERENCES

Beatty, A., S. Chamberlain and J. Magliolo (1996). Am Empirical Analysis of the Economic Implications of Fair Value Accounting for Investment Securities. Journal of Accounting and Economics, 22, 43-77.

Boehmer, E., J. Musumeci, and A. Poulsen (1991). Event-Study Methodology Under Conditions of Event-Induced Variance. Journal of Financial Economics. December, 253-272.

Boyd, J. F., G. Hayt, R. Reynolds, and C. Smithson (1996). A Review of Industry Reaction to Proposed Changes in Derivatives Accounting. Journal of International Financial Management & Accounting, Autumn, 243-258.

Espahbodi, H., E. Strock, and H. Tehranian (1991). Impact on Equity Prices of Pronouncements Related to Nonpension Postretirement Benefits (FAS 106). Journal of Accounting & Economics, December, 323-346.

Financial Accounting Standards Board (1998). Accounting for Derivative Instruments and Hedging Activities. Statement of Financial Accounting Standards No. 133, Stamford, Conn.: FASB, June 16.

Khurana, I. (1991). Security Market Effects Associated With SFAS No. 94 Concerning Consolidation Policy. The Accounting Review, July, 611-621.

Smith, R.G., G. Waters and A. Wilson (1998). Improved Accounting for Derivatives and Hedging Activities. Derivatives Quarterly, Fall, 15-20.

Samanta B. Thapa, Western Kentucky University

Christopher L. Brown, Western Kentucky University

Table 1:
Important Events and the Event Dates Leading to the Final Issuance of
Derivatives Standard

1 Exposure Draft For Derivative Standard June 20, 1996
 Issued
2 Public Comments Deadlines Oct. 11, 1996
3 Public Hearings Nov. 15, 18-20, 1996
4 Board Votes on the Final Standard June 1, 1998
5 Final Derivatives Standard Issued June 16, 1998
6 Mandatory Adoption Date June 15, 1999

Table 2: Cumulative Abnormal Returns

Event Window CAR Z-statistic P-value

Day 0 -0.26% -3.15 <.01
Day -1 to 0 -0.56% -4.44 <.001
Day -5 to +5 -1.27% -4.56 <.001