The Predictive Ability of Fair Values for Future Financial Performance of Commercial Banks and the Relation of Predictive Ability to Banks' Share Prices

For a sample of commercial banks during 1994 – 2008, we find that accumulated fair value adjustments for interest-bearing investment securities are positively associated with future interest income and total realized income from these investments. Additional tests reveal that accumulated fair value adjustments on investment securities also have predictive ability for future investment-security-related cash flows. Our analyses reveal that our predictive ability proxy for interest-bearing investment securities is positively related to the measurement precision of reported fair value measurements. We also provide evidence that the relative ability of fair values to predict reported accounting income is a factor that strengthens the association between fair values and commercial banks’ stock prices. Taken together, our study suggests that fair values have predictive ability for future income realization despite the low persistence of changes in fair value that has been extensively documented in prior studies. Further, we find that our proxy for predictive ability captures banks’ expectations of future above- or below-market relative interest income, which is a real economic condition that is incrementally reflected in current equity prices.