Banking System & Valuation Issue

Banking System & Valuation Issue

Introduction

In this paper we discuss the issues regarding fair evolution of loan which has been raised by three parties A, B and C.

A: Market Valuation of Banks' Loan Loss Provision & Auditor Reputation

Issue

The first valuation issue that party A discusses is “Market Valuation of Banks' Loan Loss Provision & Auditor Reputation”. This party considers this issue as the most important one.

Solution

Research on the association between loan losses and banks ' market value began with Beaver et al. (1997) who document that the market-to-book ratio is higher for banks with larger allowances for loan losses. Similarly, Wahlen (1994) finds a positive relation between DLLP and stock returns and future cash flows after controlling for changes in non-performing loans and loan charge-offs, indicating that current DLLP have predictive value for future cash flows. Liu and Ryan (1995) observe a positive market reaction to an increased LLP only for banks with relatively larger and more frequently renegotiated loans. Liu et al. (1997) extend the literature by documenting that increases in LLP are positively related to stock returns only for “at risk” banks in the fourth quarter. LLP of “not at risk” banks and in the first through third quarters is negatively associated with stock returns. The findings related to the fourth quarter provision are interesting because presumably, they reflect the effects of the audit process. However, Liu et al. do not examine the role of the auditor in the context of market valuation of DLLP and note that “… auditor involvement is critical, though the specific ways in which auditors exert their influence is largely unknown and requires additional research (p. 145).” In general, prior research ignores the auditor's role in market valuation of DLLP (i.e., it implicitly assumes that it has no valuation implications). Our study can be viewed as a response to Liu et al.'s (1997) call for additional research. It adds to the body of research on the stock market valuation of DLLP by examining whether auditor reputation enhances the information value of DLLP. Thus, our study opens up a new layer in the linkages between a bank's accounting information and firm valuation.

The accounting and finance literatures posit that the certification and monitoring roles of information and financial intermediaries, such as auditors and underwriters, mitigate information asymmetry between managers and investors. A number of studies find that auditor reputation mitigates underpricing of IPOs ([Titman and Trueman, 1986], [Balvers et al., 1988], [Beatty, 1989], [Datar et al., 1991] and [Michaely and Shaw, 1995]). Other studies report that the reputation of the underwriters and the venture capitalists mitigates IPO underpricing ([Carter and Manaster, 1990], [Megginson and Weiss, 1991] and [Jain and Kini, 1999]). There also is evidence that auditor reputation lowers borrowing costs of firms in the years shortly after they go public when they are lesser known (Pittman and Fortin, 2004). These findings support the notion that investors value the reputation of the auditor and other ...