Stock Price Reactionof European Financial Institutions to Announcements of a Possible

Stock price reactionof European financial institutions to announcements of a possible reclassification option in IAS 39

Master Thesis
Augusts, 2010

Erasmus University Rotterdam
Faculty: Economics and Businesses
Master: Accounting, Auditing and Control
Supervisor: Dr. Sc. Ind. A.H. van der Boom
Student:Thijs Graafland (332474)

Preface

This master thesis is the final course of the master Accounting, Auditing and Control. Writing this thesis was not always easy, but by the support and advice of other people resulted in this product. In this preface, I want to thanks the people for their contribution.

First of all I want to thank my thesis supervisor Dr. Sc. Ind. A.H. van der Boom of the Erasmus University for his clear advice, feedback and guidance during the process of writing my thesis. Furthermore, I want to thank Ernst & Young The Hague for the offered facilities to write my master theses. At Ernst & Young I want to thank especially my coach Andrew Halim for sharing his knowledge of accounting standard IAS 39, his advice and guidance.

At last, I want to thank my girlfriend, family and friends for their confidence, support and encouragements throughout the years of studying.

Rijswijk (ZH), August 2010

Table of contents

1.Introduction

1.1.Introduction

1.2.Reclassification option

1.3.Research question

1.4.Expectations

1.5.Relevance

1.6.Structure

2.The accounting standard on financial instruments and other relevant regulation

2.1.Introduction

2.2.Definitions

2.3.Categories

2.4.Measurement and recognition

2.5.Impairment

2.6.Reclassification option amendment

2.7.US counterpart and relaxation

2.8.Rules and regulations on financial institutions

2.8.1.Basel agreement

2.8.2.Solvency requirements

2.9.Corporate governance regulation

2.10.Conclusion

3.Research approach

3.1.Introduction

3.2.The research approach

3.3.Event study

3.3.1.Conducting an event study according to MacKinlay (1997)

3.3.2.Common used multi- factor model for measuring market reaction of a change in accounting standard

3.3.3.Motivation for using model(s)

3.3.4.Event windows

3.4.Conclusion

4.Prior research on economic consequences

4.1.Introduction

4.2.Capital market reaction

4.3.Background

4.4.Economic consequences of the adoption of IAS 39 in Europe

4.5.Pro-cyclical process and FVA

4.6.Pro-cyclicality and capital requirements

4.7.Economic consequences of reclassification option (Europe) and relaxation (US)

4.8.Criticism on the relaxing of FVA

4.9.Conclusion

5.Expectations and hypotheses

5.1.Introduction

5.2.First Hypothesis

5.3.Second hypothesis

5.4.Third hypothesis

5.5.Fourth hypothesis

5.6.Conclusion

6.Events and research design

6.1.Introduction

6.2.Criteria distinguishing events

6.3.Events that may have had an effect on the probability of introducing the reclassification option (relaxation)

6.4.Sample

6.5.Model selection and methodology

6.5.1.Measuring the first hypothesis

6.5.2.Measuring the second hypothesis

6.5.3.Measuring the third hypothesis

6.5.4.Measuring the fourth hypothesis

6.6.Limitations

7.Statistical results

7.1.Introduction

7.2.Evaluating the regression model

7.2.1.Homo-/heterocedasticity, linearity and outliers

7.2.2.Normality

7.2.3.Multicollinearity

7.2.4.Evaluating the model (R-square and ANOVA)

7.3.The results using the multi-factor model (multiple regression)

7.3.1.Results of the first hypothesis

7.3.2.Results of the second hypothesis

7.3.3.Results of the third hypothesis

7.3.4.Results of the fourth hypothesis

7.4.Conclusion

8.Analyses

8.1.Analysis hypothesis one

8.2.Analysis hypothesis two

8.3.Analysis hypothesis three

8.4.Analysis hypothesis four

8.5.Hypothetical situation event one through four

8.6.Conclusion

9.Summary and Conclusion

9.1.Summary

9.2.Results and conclusions

9.3.Limitations

9.4.Further research

References

Appendix A: list prior research

Appendix B: Events and sample data

Appendix C: Evaluation of the regression models

Appendix D: SPSS outcome per group

Total sample outcome

Banks and Insurance companies sample outcome

Banks sample outcome

Insurance companies sample outcome

‘Other’ financial institutions sample outcome

Appendix E: Hypothesis two

Appendix F: SPSS outcome per country

Belgium

Denmark

Germany

Finland

France

Ireland

Italy

Luxembourg

Netherlands

Austria

Portugal

Spain

United Kingdom

Sweden

Appendix G: SPSS outcome after changing predicted direction

Regression model event windows combined

SPSS outcome

1.Introduction

1.1. Introduction

In 2001 the European Union adopted a directive to modernize the accounting standardsin the EU by the introduction of the Fair Value Accounting (FVA) method (valuation at market value).The Internal Market Commissioner at that moment, Frits Bolkestein, said that the adoption of FVA would help European Companies to prepare financial statements that are accepted and understood around the world. Furthermore he said that it would help European Companies to compete with non-European competitors on equal terms in international capital markets. The main objective of thisdirective was to enable the application of the International Accounting Standards (IAS/IFRS) fully for companies. This includes the application of IAS 39, the standard for measurement and recognition of financial instruments.[1]IAS 39 is based on a mixed model of measurement and recognition at fair value and amortized costs. In 2003 the European commission adopted certain IAS, later in 2004 the European Commission (EC)endorsed IAS 39. At that time there were two carve outs, concerning the fair value option and hedge accounting. In the year 2005 the carve outs were resolved by the EC and therefore adopted in the EU.[2]Also the IFRS standards were adopted. This means that listed companies in the European Union are required to report their consolidated accounts in conformity with the adopted international accounting standards (IAS and IFRS)since 2005.[3]

The IAS standards are developed by the International Accounting Standards Committee (IASC), the predecessor of the International Accounting Standards Board (IASB). The IASB went on with the IAS rules and developed the International Financial Reporting Standards (IFRS). A number of IFRS standards include valuation at fair value, like for instance a part of IAS 39.FVA has been stimulated because of the broad consensus that it will lead to more informative and timely disclosure compared to other accounting methods like historical cost accounting. Barth et al (2001) show in a review on this topic that studies on value relevance of FVA consistently find that investors perceiveFVA of securities more relevant than historical costs accounting.However, the fair values of financial instruments fluctuate and thereforethe equity and results of a firm may fluctuate more than accounting at historical costs.

During the financial crisis in 2008 and 2009 marketsof financial instruments becameilliquid. At that time, especially from banks, there came more criticism on FVA. Due to the fact that markets become illiquid, by almost no supply or demand, FVA based on market prices did not give a fair presentation of the underlying assets and liabilities. This arose also in the market of financial instruments. Due to forced sales (fire-sales) of financial institutions, market prices decreased. As a reaction financial institutions had to mark down their financial instruments. The mark down also arises from the impairment rules on financial instruments. This impairment has an effect on the equity and income of an entity. Therefore, the impairment rules becamealso problematic during the financial crisis. This mark downfinally resulted in a negative spiral, also called by Bowen et al. (2010), Boyer (2007) and Khan (2009) thepro-cyclical effect(contagion) of FVA.

Because of the pro-cyclical contagion, the bankers and politicians started in the years 2008 and 2009 a lobby for the relaxation of FVA of financial instrument. Measurement and recognition of financial instruments is established in IAS 39, where a part of the financial instruments must be valued at fair value and another part at amortized cost, see chapter 2.There had been argued in the news (according to for instance Hughes and Tett, 2008) by bankers and politicians that FVA has contributed to the main cause of the financial crisis.The main problem of the financial crisis is in according to Ryan (2008) described as:

“The entire economic ecosystem failed to appreciate the risks of the rapid growth in risk-layered subprime mortgages, the inevitable end of house price appreciation, and unprecedented global market liquidity. These factors combined to enable all-too-human undisciplined behaviors in lenders, borrowers, and investors, all of whom were unquestioningly optimistic for as long as the sun shined upon home equity. Economic policy, bank regulation, corporate governance, financial reporting, common sense, fear of debt and bankruptcy, and all of our other protective mechanisms were insufficient to curb these behaviors.“

Also financial leaders such as the CEO’s of AXA and AIG related wide use of FVA as a major factor to the crisis.They find FVA during a financial crisis a big problem, because of the illiquidity and the pro-cyclical effect. Those two aspects are most often part of criticism on FVA. The criticism onilliquidity is in according to Veron (2008) about the market conditions of complex financial instruments which are marked by an imbalance between demand and supply. Due to this imbalance market prices melted abnormal by the evaporation of liquidity. As a result there was norelation anymore between the valuation at fair value and the underlying value of a financial instrumentrepresented by the potential to generate cash flows in the future. Criticism on thepro-cyclicality frequently refers in accordance with Veron (2008) to economic research that have shown that capital markets are not fully efficient, especially in times of speculative bubbles and collective panic, because of the information asymmetries and differences in market behavior and beliefs of market participants. Veron (2008) stated: “By granting to much relevance to markets, accounting standards would thus be culprits of accentuating both booms and busts.” Al in al, liquidity and pro-cyclicality are both linked to each other and therefore, they cannot be seen as separate parts. Furthermore, the Securities and exchange commission (SEC) and the Financial Accounting Standards Board (FASB) responded to the above problem by issuing on the30th ofSeptember 2008 a clarification on how to implement the accounting standard on FVA (FASB Press Release 2008-234). This clarification eases the requirements of valuating financial instruments at fair values if markets are inactive (Renders, 2009). At that moment rules on recognition and measurement of financial instruments in the US were less stringent compared to Europe, therefore was also argued that there was a distortion of competition.At that moment, politicians and bankers started with lobbying for reclassifying of financial instruments at FVA. This also reached the G-20[4]and the European commission.The European Commissioner Charlie McCreevy of Internal markets and Services expressed on the 1st of April2008 concerns to the impact of FVA when markets become illiquid and irrational (Charlie McCreevy testimony, 2008).David Tweedie, chairman of the IASB, mentioned in a press release that FVA could not be blamed for the financial crisis because it is not the cause of it. But he also noted that it is important that market participants have confidence in the financial statements (Leone, 2008). Later on,Tweedie had to show up for the European committee to discuss the role of the accounting standards during the credit crunch. He said that under pressure the IASB had to change the accounting standards of financial instruments, because in the US the standards were already changed. The pressure on the IASB increased because Europe felt disadvantaged compared to the US.Tweedie stated after the event that he experienced so much pressure that he considered resigning as the chairman of the IASB. He found the political pressure at the very least inappropriate (Hughes, 2008). The political interference on the standard-setters process resulted in an expeditious response of the IASB.The IASB came with an amendment of IAS 39 in October 2008. The amendment referred to the option to reclassify financial instruments.

1.2. Reclassification option

Not all categories of financial instruments have to be measured at fair value. There are also categories that are measured at amortized costs. The first step, in October 2008, made by the IASB was an amendment of the existing IAS 39 standards which madeit possible for companies to reclassify their financial instruments of some categories under certain conditions (relaxation). Reclassification means that companies could change their financialinstruments of some categories, being measured at fair value, to another categorywhich is measured at amortized costs. Further explanation of thereclassification option will be described in chapter 2, for now it isimportant to know that financial institutions were allowed to reclassify some of their financialinstruments. This has the advantage that financial institutionsactive at markets which becameilliquid during the financial crisis, do nothave to deal with the valuations at market prices. This means that financial institutions have to write offless during a financial crisis when using amortized costs instead of FVA and therefore less effect in the income statement. The main goal of this reclassification option was to ensure that financial institutions are not disadvantaged by the accounting rules and interpretations with respect to international competitors.In the US the reclassification option was already possiblefor financial institutions and therefore thisamendment reduce the differences between the IFRS standards and US GAAP (Renders, 2009).[5]TheCESR[6]did aresearch on the use of the possibility to reclassify financial instruments. They studied theannual accounts of 100 large financial institutions in Europe and found that 61% of themmade use of the possibility of reclassification in 2008 (CESR, 2009).

The G20 called the regulators on April 2009 to reduce the complexity of the accounting standard on financial instruments, especially the methods of FVA measurement and to address a number of specific points.[7] Later the EU finance ministers (ECOFIN) speak out the same message and recommended the IASB to work closely together with the Financial Accounting Standards Board (FASB). As a second step, the IASB responded to this calls and introduced on July14, 2009 a final exposure draft. With this draft the IASB wants to reduce significantly the complexity and makes it for investors easier to understand. With this project, IAS 39 would be replaced by a new standard called IFRS 9, it will replace IAS 39 finally in 2013 but phase 1 (recognition and measurement) is already allowed to use it in 2009. However on December 21, 2009 the European commissiondid not endorse IFRS 9. This means thatthe use of IFRS 9 is not allowed in the European Unionfor now.

1.3. Research question

In thismaster thesis I examinethe economic consequences of the announcements,concerning the probably of the introduction of reclassification option inIAS 39,on the stock prices of financial institutions.This examination will be conducted using an event study. The events areannouncements which might have had an impact on the probability of changing by the reclassification option or retaining the standard.The announcements are statements of persons or organizations that might have hadan influence on the standard-settings process. Bowen et al. (2010) have done a similar research in the US. They found a positive (negative) market reaction on announcements which increase (decrease) the possibility of relaxing FVA of financial instruments. The situation in the US is not the same as the situation in Europe, as described above. Moreover, there are important differences between Europe and the US, for instance accounting standard, market reaction and corporate governance structure.This will be discussed later. Because of the differences and different situation between the US and Europe, this research will focus onthe reaction of the European capital markets. Therefore, the research question will be as follows:

How did the stock prices of listed banks, insurance companies and other financial institutions in Europe react to announcementsconcerningthe probability of the introduction of reclassification optionin IAS39?

This research question will be answered using the following sub-questions.

1)What are the requirements of recognition and measurements of financial instruments in IAS 39, what does the reclassification option mean andare there specific regulation applicable to financial institutions which might have an impact on this research?

2)What will be the research approach?

3)What are theresults of prior research onthe economic consequences of the introduction of FVA, IAS 39 and the relaxation of FVA?

4)What are the expectations and hypotheses regarding the capital market reaction on the events?

5)What is the suitable research design to give answer to the research question?

6)What are the results after conducting the research model and how to interpret them?

The focus of this research lies on financial institutions because they have to deal a lot more with IAS 39 than other sectors. This means that effect of the reclassification option under IAS 39 on the stock priceswill be more interesting for financial institutions, because of the relative importance of financial instruments. By for instance banks and insurance companies, the total amount of financial instruments is very high, sometimes up to 90% of the balance total. For other financial institutions like Real Estate Services this percentage is a bit lower, around 25%.[8] The sample of this research consists of financial institutions of 15 member states of the European Union, which are member until 1995. Because this are the largest economies of the European Union. The sample selection is described in chapter nine.

1.4. Expectations

Because the main goal of thereclassification option under IAS 39 was to reduce the differences in accounting standards between IFRS and US GAAP, and the positive capital market reaction in the US, to the relaxation of FVA, I expect that there has to be also a positive return on the stock marketaround the events that lead to thepossibility of reclassification in IAS 39. When the capital market reacts negatively, you might conclude that the whole process that leads to the reclassification was not necessary and the contrary applies for a positive market reaction.On the one hand, based on the semi-strong form of the efficient market hypothesis of Fama (1970), it is reasonable to expect that a reclassification of figures does not lead to new public available information and therefore no market reaction. However, a positive (negative) reaction could indicate whether the capital market is satisfied (dissatisfied) with the reclassification option and lead to new information. A positive (negative) market reaction could also indicate that the capital market is discontent (content) about FVA of financial instrument.On the other hand, based on prior research, which shows a market reaction on a probable introduction and relaxation of FVA, I also expect a market reaction during the events. In a similar study of Bowen et al. (2010) is shown that, the capital market in the US react positive on the announcements of a probable relaxation of FVA. I expect that the market reaction in Europewill differ from the reaction in the US, because of the different situation and the differences between Europe and the US. In chapter four, the reason for this expectation is explained.