The impact of fair‐value‐accounting on the relevance of capital adequacy ratios

Abstract

PurposeThis study aims to empirically investigate whether the adoption of fair‐value‐accounting decreases the relevance of banks' capital adequacy ratios (CARs) in explaining insolvency risks. Additionally, how the disclosure quality affects the superiority of fair‐value‐based CARs over cost‐based CARs is also explored.Design/methodology/approachUsing data from Taiwan banks from 2004 to 2010, the following tests are conducted. First, the insolvency risk is regressed on the reported CAR, along with the related interaction with the adoption of TFAS No. 34 to test the weakened relevance of CARs during the post‐TFAS No. 34 periods. Second, the relative relevance of fair‐value‐based CARs and cost‐based CARs is assessed using Vuong's Z‐statistic. Lastly, observations are partitioned into two groups – banks of higher and lower disclosure quality – to investigate whether fair‐value‐based CARs is superior (inferior) to cost‐based CARs for banks with higher (lower) disclosure quality.FindingsFirst, adopting TFAS No. 34 reduces the relevance of CARs in explaining banks' insolvency risks. Second, fair‐value‐based CARs are superior to cost‐based ones in relation to insolvency risks only for banks of higher disclosure quality.Originality/valueThis study is the first to fill the empirical gap by demonstrating that the ability of CARs to explain the insolvency risk is adversely influenced by the adoption of fair value accounting. In particular, the results shed some light on the move toward fair‐value accounting, and may be interpreted that adopting fair‐value reporting is not flawless, drawing attention to the potential information loss in abandoning historical‐cost‐based regimes. Moreover, because the application of fair‐value accounting in the Taiwan banking industry is fairly similar to that of international or US GAAP, these results also yield insights into other standard‐setters.