Impact of disclosure and corporate governance on the relevance of fair value gains and losses in the commercial banking industry

This thesis investigates whether the quality of bank's fair value gains and losses (FVGL) as perceived by the market participants is a function of its risk management process for a sample of 180 U.S. commercial banks for the period 2003--2005. To capture the market's perception of the quality of FVGL, I use two complementary measures of market association---value relevance measured as the association between stock returns and FVGL based on the returns model and risk relevance measured as the variance contribution of FVGL to the volatility of unexpected stock returns based on the variance decomposition model (VD model). As bank's actual risk management process is unobservable to outsiders, I use disclosure relating to the risk management activities and corporate governance to measure the effectiveness of this process. The returns model-based tests suggest that the FVGL-returns association is significant only when conditioned on disclosure. In contrast, the VD model-based tests show that FVGL are significant unconditionally in explaining the volatility of unexpected returns. Both the FVGL-returns association and the relative variance contribution of FVGL to the volatility of unexpected returns are increasing in disclosure. The effect of corporate governance operates indirectly through the medium of disclosure. Further, I classify disclosure by type of risk and find that both the FVGL-returns association and the relative variance contribution of FVGL increase with the level of disclosure related to interest rate risk, credit risk and derivatives risk for banks that are exposed to these risks. Overall, the results suggest that disclosure aids market participants directly, whereas corporate governance aids market participants indirectly (via disclosure) in evaluating the fair value estimates.