The study focusses on price-to-book ratios (P/Bs) as one metric investors monitor when valuing banks and as a metric widely referenced by policymakers as a yardstick for the financial health of banks. It is based on a sample of 51 banks (31 from the European Union and 20 from Australia, Canada, Japan, and the United States). The sample includes large, complex banking groups and the analysis period is 2003–2013, i.e. it covers the periods before, during, and after the financial crisis.
A key analytical angle in the study concerns the relationship between loan impairments and P/Bs as loans are a key element of a bank's financial assets, and their impairments affect both the market value of equity (stock price) and the equity. The survey coincides with a (not yet published) survey by the CFA Institute identifying improved requirements in the accounting for impairments as the second-most important required regulatory reform to avert future financial crises and the current initiatives from IASB (the final version of IFRS 9 Financial Instruments is expected to be issued later this month), the FASB, and other regulatory bodies aimed at improving the accounting for financial instruments and the overall transparency of banking financial institutions.
The study shows that during the financial crisis, the representation of loan impairments on balance sheet and non-performing loans lagged the capital markets' economic writedown of these loans and this lagging trend was particularly evident for the EU banks. In addition, comparing the pre-provision income and net income for the sample banks showed that loan impairments significantly contributed to reduced overall net income at different junctures during the financial crisis. The authors of the study also found an incremental risk aversion toward the bank sector, translating to relatively higher risk premiums, lower stock prices, and lower P/Bs.
Based on these findings, the report contains two major policy recommendations:
- In addition to amortised cost carrying values, fair value measurement of loans should be recognised on the face of the balance sheet as a means of avoiding "too little, too late" recognition of loan losses and providing decision-useful information.
- Bank risk disclosures should be enhanced as a better understanding of bank business models reduces the risk premium that investors assign owing to limited transparency of bank financial statements.
The report is available for download on the CFA Institute website. The CFA Institute has announced that part 2 of the report, Relationship between Disclosed Loan Fair Values, Impairments and the Risk Profile of Banks, will be released in August 2014.