The financial crisis has presented a monumental opportunity for incisive reflection on and reform of deficiencies in the current financial reporting framework. These deficiencies have contributed to the limited transparency of bank financial statements. One feature of the crisis that begs for a keen review of its causes and implications is the sustained depressed (i.e., less than 1) price-to-book ratios (P/Bs) of banks during the crisis. P/B and other closely related measures, such as the price-to-tangible-book ratio (P/TB), are key bank valuation metrics.
Although P/B is one of many metrics that investors monitor when valuing banks, CPA Institute focuses on it in its study because it is widely referenced by policymakers as a yardstick for the financial health of banks. Another key concern regarding the pattern of long-term-depressed P/Bs of banks is that it undermines the investability of the banking sector. Equity issuance becomes less attractive if equity is considered too cheap by issuing banks.
A key analytical angle in this study concerns the relationship between loan impairments and P/Bs. 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 book value of banks. Loan impairments are widely applied and considered important by investors, as shown in a ECB survey of leading banking analysts.
One principal issue for investors and other financial reporting stakeholders during the financial crisis was the extent to which the amount and timing (too little, too late) of financial asset (e.g., loan) impairments contributed to overstated reported balance-sheet net assets and, thereafter, to depressed P/Bs. Thus, it is not surprising that the CFA Institute 2014 Global Market Sentiment Survey (GMSS) report identified improved requirements in the accounting for impairments as the second-most important required regulatory reform to avert future financial crises (73% of survey respondents called for improvements in the requirements to impair troubled credit holdings). Correspondingly, the timing of our study is aligned with the significant raft of current initiatives from the IASB, the FASB, and other regulatory bodies aimed at improving the accounting for financial instruments and the overall transparency of banking financial institutions. It also highlights the importance of the asset quality review being conducted by the ECB and other regulators.
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