John Shon addresses banks’ fair value disclosures and SEC “Dear CFO” letters

Associate Professor John Shon co-authored an article titled “Information Asymmetry and Voluntary SFAS 157 Fair Value Disclosures by Bank Holding Companies: The Role of the SEC’s ‘Dear CFO’ Letters during the 2007 Crisis,” which was accepted by the journal Accounting Perspectives.

In the midst of the 2007 to 2008 financial crises, the Securities & Exchange Commission's Division of Corporate Finance sent letters to the largest 18 bank holding companies to strongly encourage them to increase their voluntary disclosures. These letters, commonly referred to as “Dear CFO letters,” represented an unprecedented move by the SEC because they did not mandate any new disclosures, but merely encouraged additional and more specific voluntary disclosure.

At the time, the SEC believed that the additional disclosure would help to reduce the large information asymmetries that existed in the market during the financial crisis. (Information asymmetry refers to the degree of opacity in information between the bank and shareholders buying and selling the stock, a good proxy for which is the bid-ask spread of the bank’s stock price.

Associate Professor Shon and his co-authors read the Dear CFO letters to assess the additional voluntary disclosures that the SEC explicitly encouraged; by their count, there are 20 items. They then collected the SEC 10-K and 10-Q filings for each of these 18 banks, tabulated each bank’s disclosures as they related to the items encouraged in the Dear CFO letter, and performed factor analysis to generate eight common-themed disclosure items.

The article finds that banks’ disclosures about the use of broker quotes or prices from pricing services and the use of market indices and illiquidity adjustments are related to lower information asymmetry. However, disclosure variables about valuation techniques and asset-backed securities are related to greater information asymmetry. The article also documents that the degree of complexity in disclosures, as well as the tone of such disclosures, tend to increase information asymmetry. The findings suggest that management’s disclosures seem to obfuscate/mask unfavorable information, which in turn increases market participants’ assessment of uncertainty associated with banks’ fair value measures.