The Relationship Between Fair Values in Banks’ Trading Books and Volatility in Share Price Returns in the Indian Context

‘Fair value’ of an asset or a liability refers to the amount at which such an asset could be exchanged, or the liability settled, between knowledgeable, willing parties, in an arm’s length transaction. Although the growing irrelevance of historical cost-based accounting numbers in the financial statements, in the wake of developments in financial markets and advancements in technology, has triggered off the debate on fair value accounting a decade and a half ago, some issues still stand in the way of extensive application of fair value accounting framework. One such issue is the excessive level of volatility in the financial statements induced by fair valuations and its resultant impact on the flight of capital from the firm’s equity. In accordance with the series of guidelines issued by the Reserve Bank of India between 1995-2000, fair value accounting has been applied only on the ‘held for trading’ securities in banks’ investment portfolio in India till today. Accordingly, this research paper makes a modest attempt to examine whether fair valuations in banks’ trading books bring about an increased volatility in banks’ stock returns over the time period 1994-1995 to 2007-2008, using a sample of Indian banks and bank index, i.e., BSE BANKEX, and autoregressive and multiple linear regression techniques.