Application of the Fair Value Option Under IAS 39 : Effects on the Volatility of Bank Earnings

This study examines whether the application of the fair value option (FVO) induces different levels of earnings volatility during the time period from January 2006 until July 2007 using an international sample of 227 banks from 42 countries. Although fair value accounting is generally believed to increase earnings volatility, I find evidence that banks applying the FVO with the intention of reducing accounting mismatches report lower levels of earnings volatility than the control group. The empirical cross-sectional results are robust against outliers and several model modifications, including controls for endogeneity bias. The results remain constant for an extended period of time including the third and fourth quarters of the year 2007, during which time bank earnings were affected substantially by the US subprime crisis. Overall, the findings confirm the IASB's initial intention on introducing the FVO and should be considered for future standard setting on the accounting for financial instruments