Banks’ Accounting Discretion over Debt Valuation Adjustment for Own Credit Risk on Liabilities

Gains or losses of debt valuation adjustment (DVA) stemming from the change of a firm’s own credit risk have been controversial and since the recent financial crisis, been criticized as accounting abominations. Using European listed banks over the period of 2008-2013, we first investigate the determinants of the non-discretionary part of DVA. Consistent with the DVA definition, our results indicate a positive association between the change in bond yield spread and DVA, implying that when credit risk is higher, banks are more likely to generate a larger positive DVA. After decomposing the total DVA into the discretionary (abnormal) and the nondiscretionary parts, we examine accounting discretions associated with DVA in smoothing earnings, while controlling for abnormal loan loss provision (LLP) and the realization of securities gains or losses (RSGL). We find that pre-managed earnings are negatively associated with abnormal DVA during the financial crisis, that is, when pre-managed earnings are low, banks are likely to report high DVA and vice versa. The interaction model also shows a complementary relationship between the abnormal DVA and abnormal LLP