Reliability and relevance of market risk disclosures by commercial banks
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This dissertation examines the relevance and reliability of mandated market risk disclosures of commercial banks. I assess reliability by examining the extent to which the disclosures are associated with future changes in income or fair values, conditional on actual changes in market factors. To evaluate the relevance of market risk measures, I provide evidence on the extent to which these disclosures are useful in explaining the firm's cost of equity. If the disclosures measure risks that investors consider when valuing stocks, then firms with disclosures indicating greater market risk should have higher costs of equity. In addition, I address two ancillary research questions. The first is whether reporting discretion enhances or impairs the relevance and reliability of market risk measures. To examine this issue, I compare the results for regulatory disclosures which permit very little discretion with results for SEC disclosures which permit a great deal of discretion. The second ancillary question is whether alternative bases of risk measurement (risk of income loss and risk of fair value loss) are each reliable and relevant measures of risk. Current SEC disclosure requirements treat fair value and income risk as interchangeable alternatives. I investigate whether income and fair value sensitivity disclosures are distinct risk constructs by assessing the incremental usefulness of each measure for explaining cross-sectional variation in the cost of equity. Results show that market risk measures are reliable in the sense that they are associated with actual future changes in income and fair values. However, these results are much stronger for regulatory disclosures that allow very little discretion. This suggests that the reliability of market risk disclosures is decreasing in the amount of discretion allowed by reporting standards. Consistent with their greater predictive accuracy, regulatory risk disclosure amounts are positively associated with the cost of equity, while SEC risk disclosures are not. In addition, each of the regulatory income and fair value disclosures is positively and incrementally associated with firms’ costs of equity suggesting that these measures are complementary rather than interchangeable risk measures. Results are robust to alternative specifications and alternative measures of risk.