International Variation in Bank Accounting Information Content

Journal of International Financial Management and Accounting 19:3 2008
International Variation in Bank Accounting

Information Content
Ronald Zhao and Yihong He
Department of Accounting, Monmouth University, West Long Branch, NJ 07764, USA
e-mail: rzhao@monmouth.edu, dhe@monmouth.edu
Abstract
This study explores the cross-country impact of nancial system and banking regulations
on the information content of bank earnings and book value. Test results provide
empirical evidence that nancial system and banking regulations have a joint eect on
the association of equity price with earnings and book value components in Germany,
France, the United Kingdom and United States. This eect is explainable by the objective
bank function, which shows that earnings of the period determine the terminal book
value, thus consistent with the clean surplus accounting approach. Cross-country variation in bank accounting information content calls for caution in interpreting international
bank nancial and operating ratios.
1. Introduction
The accelerating globalization of the world economy and integration of
capital markets has led to a proliferation of research on the value
relevance of accounting information across countries, with a focus on
international diversity of earnings quality (e.g., Pope and Walker, 1999;
Ali and Hwang, 2000; Ball et al., 2000) and earnings management (e.g.,
Brown and Higgins, 2001; Bhattacharya et al., 2003; Leuz et al., 2003).
However, based exclusively on industrial/commercial rms, the extant
literature is not generalizable to nancial institutions including commercial banks, which dier signicantly from industrial/commercial rms in
terms of operating characteristics and reporting requirements.
In contrast to the shortage of international accounting studies on
nancial institutions, comparative works on bank eciency and protability abound in economics and nance literature. For example, Berger
and Humphrey (1997) surveyed 130 studies that applied frontier eciency analysis to nancial institutions in 21 countries, and found that
the various eciency methods did not yield consistent results. We argue
that, to an extent, the mixed results are attributable to cross-country
The authors want to thank Professor Frederick D.S. Choi (the Editor) and two anonymous
reviewers for their constructive comments and helpful suggestions.
r 2008 Blackwell Publishing Ltd., 9600 Garsington Road, Oxford OX4 2DQ, UK and 350 Main Street, Malden, MA 02148, USA.
International Variation in Bank Accounting Information Content
237
variation in bank accounting information content from which international bank nancial and operating ratios are derived. Hence, the need
for a paper to explore the international variation in bank accounting
information and ratio analysis.
Banking is a regulated industry owing to the important intermediary
role banks play in national nancial systems. Each country has its own
regulations for bank capitalization, risk exposure and information
disclosure to address the three fundamental sources of systematic risks
for bank operations: interest risk, credit risk and liquidity risk (Stigum
and Branch, 1983). However, despite their national diversity, commercial
banks have a relatively simple and homogenous production function and
capital structure because they specialize in transforming deposits into
loans and investments, as compared with industrial/commercial rms
engaged in heterogeneous business activities. This production function
provides a feasible basis for identifying the impact of various institutional factors on bank accounting information content.
Our study investigates the variation in bank accounting information
content for France, Germany, the United Kingdom and United States.
All the four countries are members of both the OECD and G-10 group,
characterized by a compatible level in economic development and
nancial market sophistication.1 Nevertheless, signicant dierences
exist among their nancial market structures and banking regulatory
regime. The United Kingdom and United States (France and Germany)
are examples of shareholder (creditor)-oriented nancial systems, with
equity playing a signicantly more (less) important role than bank loan
as a funding source for rms. Whether a country has a shareholder- or
creditor-oriented nancial system is important because each type of
systems has dissimilar implications for dealing with potential asymmetric
information problems that arise between those providing the funds and
those receiving them. Furthermore, commercial banks have been permitted a varying range of allowable activities in the four countries with
France (the United States) as the most deregulated (regulated) one in
terms of engaging in securities, insurance and real estate activities. The
motivation of the paper is to examine how the dierent sets of institutional factors aect accounting information content across the four
countries, thereby leading to varying value relevance of international
bank accounting information and nancial/operating ratios.
The next section reviews the balance sheet and income statement of
commercial banks and develops testable hypotheses. Section 3 describes
the test sample and reports empirical results. Section 4 concludes the paper.
r 2008 Blackwell Publishing Ltd.
238
2. Hypotheses development
2.1 Financial Statements of Commercial Banks

Analysis of the nancial statements of commercial banks involves
exposure to some accounts and ratios that are dierent from those of
industrial/commercial rms. The global nancial system has experienced
several important changes over the past few decades. Simultaneous with
the transformation of the banking industry, the development of money
markets and mutual funds have created new possibilities for rms to
nance their investments and for investors to allocate their funds. These
changes directly or indirectly inuenced the information content of bank
balance sheets and income statements, which are illustrated as follows:
(Figures 1 and 2)
One recent development in banking that had signicant implications
for the evolution of balance sheet is the increase in importance of obalance-sheet activities. Some of the most common o-balance-sheet
activities are the provision of line of credit, the securitization and sale of
loans, and the trading of derivative instruments. Obviously, the changes
in the structure of the industry and in the composition of the balance
sheet will aect their ability to meet the capital adequacy requirements as
well as the sources of income for banks.
There are ve main components of the income statement of commercial banks. Interest income is the result of all interest and dividend earned
by banks on interest-bearing assets (such as loans and leases). Interest
expense is the result of all interest paid to depositors and other creditors
of the bank. Non-interest income includes fee income, gain on securities
transactions, and all other income not originated in interest payments.
Non-interest or Operating expense includes personnel compensation,
legal expenses, oce occupancy and equipment expenses. Finally,
provision for loan losses is the amount charged as operating expenses
Figure 1. Balance sheet.

Assets
Liabilities
Cash
Deposits
Loans and Leases
Borrowed Funds
Securities
Others
Others
Stockholders Equity
239
Figure 2. Income statement.

Interest Income
Interest Expense
+Non-interest Income
Non-interest Expense
Provisions for Loan Losses
Others
Net Income
to provide an adequate reserve to cover anticipated losses in the loan

portfolio. These charges become part of the allowance for loan losses, a
deductive component from the asset on bank balance sheet, which is then
used to charge o loans after they become non-performing.
The institutional design of banking supervision has been emphasized
to eliminate moral hazard bias and strengthen market discipline in the
banking industry. The strategy of eliminating moral hazard consists in a
sharpening of capital requirements for banks and restriction with regard
to banking operations. In the context of the strategy to enlarge market
discipline in the banking system, an important issue relates to the
availability and quality of bank accounting information. To further
this objective, the International Accounting Standard Committee issued
IAS No. 30: Disclosure in the Financial Statement of Banks and Similar
Institutions (reformatted, 1994).
The quality of bank accounting information is essential in the working
of the market mechanism because market participants base their economic decisions on the information. Quality information on capital
adequacy and earnings ability provide a more accurate picture of the risk
exposure and the nancial cushion of the bank. As information moves
market prices, increased bank nancial transparency complements regulatory supervision and promotes market discipline. We develop three
hypotheses to test market response to the value relevance of crosscountry bank accounting information.
2.2 Capital Requirements

The primary criterion in bank supervision involves capital adequacy
standards, for which the International Committee on Banking Supervision
240
adopted the Basle Accord in 1988 and Basel Accord II in 2005. The Basle
Accords specify denitions of Tier 1 (core) capital (stockholders equity),
Tier 2 capital (additional components of capital), and a general framework for assigning assets and o-balance sheet items to broad risk
categories to enable the calculation of risk-based capital ratio. A
minimum ratio of total capital (Tier 1 plus Tier 2) to risk-weighted
assets of 8 percent (of which at least 4 percent should be in the form of
core capital) was specied in 1992. Although the Basle Accords are
viewed by many as providing uniform minimum capital requirements, it
does not aect banks in each country equally because there are
dierences in the items that may be included as components of capital
for purposes to fulll the requirements. Table 1, panel A lists the
components of regulatory capital for meeting the capital requirement
in the four countries.
Failure to meet capital adequacy would increase banks cost of
capital, thus resulting in lower equity value. Bank managers can
increase regulatory capital through the combination of its components
(Moyer, 1990). Thus, dierences in the composition of regulatory
capital constitute a major source of cross-country variation in the
information content of capital adequacy for commercial banks. The rst
hypothesis is:
H1 : The association of market valuation with asset risk for capital
adequacy of commercial banks dier signicantly between countries.
The following model can be used to test Hypothesis 1:
MVit a b1 CCit b2 RCit b3 Di b4 CCit Di b5 RCit Di
eit
1
where MVit 5 market value of bank is common equity at the end of year
t, CCit 5 contributed capital of bank i at the end of year t, RCit 5
reserved capital of bank i at the end of year t, Di 5 system/country
dummy for bank i, CCit Di 5 interaction of CCit and Di,
RCit Di 5 interaction of RCit and Di, eit 5 disturbance term.
Contributed capital (CC) consists of capital stock and additional paidin capital, which represent the legal capital requirement for an incorporated commercial bank and cannot be distributed to shareholders except
under liquidation. Reserved capital (RC) includes retained earnings,
other distributable and non-distributable reserves (e.g., unrealized securities gains/losses, xed asset revaluation reserve), which reect the
(a)Based on Barth et al. (1997).
Securities
Insurance
Real estate
Investment in nonnancial rms
Nonnancial rm investment in commercial banks
Permissible Banking Activities:

Unrestricted
Permitted
Permitted
Unrestricted
Unrestricted
France
No
Yes
No
No
No
Yes, but not prevalent
Yes
Yes, but not issued
Yes
No
Yes
Yes, but limits
Panel B: regulations on bank operating activities(a)
Perpetual preferred stock

Current year prot (loss)
Goodwill
Other intangible assets
Undisclosed reserves
Hybrid capital instruments
Subordinated term debt
Limited life redeemable preferred stock
Fixed asset revaluation reserves
Hidden revaluation reserves
General loan loss reserves
Investment in other nancial institutions
France
Yes
No
No
No
Yes,
Yes,
Yes,
No
No
Yes,
Yes,
No
Unrestricted
Restricted
Permitted
Unrestricted
Unrestricted
Germany
but limits
but limits
but limits
but limits
but limits
Germany
Panel A: components of capital for meeting the capital requirements(a)
Table 1.
Unrestricted
Permitted
Unrestricted
Unrestricted
Unrestricted
UK
Yes
Yes
No
No
N/A
Yes, but limits
Yes, but limits
Yes
Yes, with caution
N/A
Yes, but limits
No
UK
Yes
Yes
No
No
No
Yes,
Yes,
Yes,
No
No
Yes,
No
Restricted
Restricted
Restricted
Restricted
Restricted
US
but limits
but limits
but limits
but limits
US

241
242
additional components of bank capital. We expect both CC and RC to be

signicant in relation to market value as proxies for Tier 1 and Tier 2
capital, respectively.
We run each model twice by using the dummy to discriminate between
shareholder- (D 5 0) and creditor-oriented (D 5 1) systems the rst time,
and to distinguish among the four countries (D 5 0 for the United States,
D 5 1 for France, D 5 2 for Germany, and D 5 3 for the United Kingdom) the second time. In the rst run, the interaction terms of CC D
and RC D will show the between-group dierence of France and
Germany (creditor-oriented system) from the United Kingdom and
United States (shareholder-oriented system) because equity plays signicantly dierent roles as funding source between the two groups. The
shareholder-oriented system reports book value of equity with higher
transparency, leading to a stronger association with market price. The
second run will further indicate the within-group dierence between
countries within each system due to dissimilar banking regulation in
capital requirement (Table 1, panel A), which would aect the extent of
discretionary items in bank capital. For example, we expect the interaction term of CC D and/or RC D for France to be more signicantly
dierent than those for Germany relative to the United States (shareholder-oriented system), though both France and Germany belong to the
creditor-oriented system. Within the shareholder-oriented system, the
CC D and/or RC D for the United Kingdom would also demonstrate signicant dierence between banks in the United Kingdom and
United States.
2.3 Income Smoothing

Managers in creditor-oriented markets are inclined to smooth earnings
to conform more closely to dividend and employee bonus policies and
requirements of tax authorities by increasing (decreasing) discretionary
accruals in good (bad) years (Ball et al., 2000). Income smoothing
involves the manipulation of the time prole of earnings to reduce the
uctuations of publicly reported earnings in order to enhance investors
ability to predict future cash ows, while not necessarily increasing
reported earnings over the long run (Zhao and He, 2004). In particular,
bank management has strong incentives to smooth earnings in order to
maintain public condence in the banking system. Income smoothing
could reduce banks bankruptcy risk as perceived by investors and
regulators. Moreover, the reduced bankruptcy risk may arguably lead
243
to a lower cost of capital, and therefore, a higher market valuation for

banks (Trueman et al., 1988). Income smoothing would also have a
benecial eect on the evaluation of bank management performance by
providing an alternative for low-quality management to project an image
of high-quality management, contributing to their reputation capital
(Johnson, 1997). For instance, earnings stability is one of the criteria in
the CAMEL model used by US banking regulatory agencies for supervising bank performance.2
France, Germany, the United Kingdom and the United States dier in
permissible securities, insurance and real estate activities for banks
(Table 1, panel B), which generate non-interest (operating) revenues, as
opposed to interest revenues from traditional bank borrowing and
lending activities. National regulations on permissible bank activities
across countries would dominate the income smoothing behavior of
banks, and as a result, aect the quality of their earnings components. It
would require an optimal balance between market and regulatory
discipline to constrain both the kind and extent of risky activities in
which banks engage. The second hypothesis is developed as follows:
H2 : The association of market valuation with earnings components for
commercial banks dier signicantly between countries.
We use a bank earnings decomposition model to test how the market
responds to interest, non-interest and other income components in the
four countries:
MVit a b1 NIIit b2 NNIIit b3 ONIit b4 Di b5 NIIit Di
b6 NNIIit Di b7 ONIit Di eit
where MVit 5 market value of bank is common equity at the end of year
t, NIIit 5 net interest income for bank i in year t, NNIIit 5 net noninterest
income for bank i in year t, ONIit 5 other net income for bank i in year t,
The dummy and interaction terms are as explained in Equation (1).
NII is the dierence between interest income and interest expense,
while NNII is the dierence between non-interest income and noninterest expense. The variable ONI consists of other nonrecurring income
items such as foreign exchange income, exceptional items and other
provisions/reserves. NII and NNII are expected to have positive signs in
relation to market value because they provide primary recurring sources
of earnings for banks functioning as nancial intermediaries. On the
other hand, ONI, which includes various types of provisions and other
244
nonrecurring earnings, would have weaker association with market value

especially if it is used as income smoothing tool. More stringent
regulations on banking operations increase the information content of
earnings components because they reduce managements choices of
discretionary accruals via various types of operating activities for income
smoothing by restricting banks permissible activities, thus leading to
higher earnings and earnings components quality.
As France, Germany and the United Kingdom allow for more
permissible bank activities than the United States, their banks are
more likely to have a greater scope for earnings management through
various accruals, therefore, weakening the association between banks
earnings and market valuation. Consequently, we expect a signicantly
negative interaction of NII D and NNII D for the creditor-oriented
system in the rst run. In the second run, NII D and NNII D for the
three countries are also expected to be signicantly dierent as compared
with the United States, though both the United Kingdom and United
States fall under the shareholder-oriented system. The interaction term of
ONI D would further reect the relative extent to which it is used as an
income smoothing tool in each of the countries.
2.4 Equity Valuation

We separately examine the accounting implications of nancial system
and banking regulations for book value and reported income of
commercial banks in the preceding sections. However, it is dicult to
isolate a banks demand for increasing earnings from its demand for
regulatory capital because earnings is also a source of capital. In this
section, we test the linear information dynamic between bank earnings
and book value components across the four countries.
Santomero (1984) modeled the nancial intermediary role of a bank as
a microeconomic rm that attempts to maximize an objective function in
terminal wealth, and he generalized the optimization function as follows:
E VWt T
WtT Wt 1 Pt1 1 Pt2 . . . 1 PtT
Maximize
Subject to

PtT Si gi Ai Sj dj Lj CAi Lj =WtT1
PtT =WtT1
245
where V(n) is the objective function, where @V/@WX0 and

2
; 0. Wt1T is the value of terminal wealth at the horizon
@ 2 V=@WtT
time. Pt1T is the stochatic prot per unit of capital during period t1k, where
04ko 5 T. pt1k is single period prot for period t1k. gi is the stochatic
return on asset i. Ai is the asset category i, where 14i4n. dj is the stochastic
cost for deposit j. Lj is the depository category j, where 14j4m. C(n) is the
operations cost function, where @C/@AiX0 for all i and @C/@LjX0 for all j.
Equation (a) is the general form of the objective function to be
maximized by the bank. In Equation (b), the general specication is
dened as a multi-period valuation problem. Equation (c) denes prot
per unit of capital invested by the owners. Solving (a), (b), and (c) results
in a joint decision of portfolio structure and leverage, which determines
the banks terminal wealth. Using reported earnings to proxy for pt1k
and book value for Wt1k, this objective function conceptually agrees
with the clean surplus accounting approach to the linear information
dynamic between reported earnings and book value.
According to the clean surplus approach, the valuation of a rm equals
to its book value of equity, current protability as measured by (abnormal) earnings, and other information that aect the prediction of future
protability (Feltham and Ohlson, 1995; Ohlson, 1995). This linear
information dynamic assumes that the value of a bank can be approximated by a function of forecasted earnings, book value and discount rate
over a nite horizon, if these forecasts are consistent with the clean surplus
relation. The clean surplus relation imposes two restrictions: rst, discount
rates are constant across rms; and second, accounting conservatism is
constant across rms. These two conditions are more applicable to banks
than industrial/commercial rms because of the homogeneity in bank
production function and capital structure. Based on the clean surplus
approach, the third hypothesis tests the joint eect of nancial system and
banking regulations on the variation in the linear information dynamic
framework for commercial banks across the four countries:
H3 : Financial system and banking regulations have a signicant impact
on the linear information dynamics for commercial banks.
The empirical model is as follows:
MVit a b1 CCit b2 RCit b3 NIIit b4 NNIIit b5 ONIit
b6 Di b7 CCit Di b8 RCit Di b9 NIIit Di
b10 NNIIit Di b11 ONIit Di eit

246
The denitions of the variables are the same as in Equations (1) and (2).
b1 and b2 are multiplicative parameters that relate book value to
market value. If book value is equivalent to capitalized normal earnings,
then rm value is equivalent to the sum of capitalized normal earnings
and capitalized abnormal earnings, or simply capitalized earnings. b3, b4
and 5 are earnings capitalization factors that take into account crosscountry dierences in risk, expected growth and other factors. In the
valuation framework of the clean surplus model, book value is assumed
to provide information on normal earnings, and abnormal earnings is
captured in the linear information dynamics between accounting earnings and book value. More stringent banking regulations are expected to
have a positive impact on the linear information dynamic for commercial
banks because, holding everything else constant, current periods income
determines terminal wealth.
Recall that signicant dierence exists between France and Germany
(Germany, France and the United Kingdom) versus the United Kingdom and United States (the United States) in terms of capital requirement (earnings components) in H1 (H2). We expect signicant dierence
in the linear information dynamic, rst between the shareholder- and
creditor-oriented systems, and then between the United Kingdom in
addition to France and Germany versus the United States, because the
variation in earnings quality would aect that of the capital components.
3. Empirical Tests
3.1 Data Description

The nancial and market data were retrieved from Compustat Global
Financial Service File for the period of 1994 to 2004. The test data
contains a sample of commercial banks in each of the four countries with
SIC codes 60216022. Only banks with $100 million and above in total
assets are included in the test sample to control for size eect. Foreign
monetary units were translated into US dollar based on year-end
exchange rate. All variables were scaled by the square root of total
assets for the regression tests. The requirement of complete data set for
each observation results in 325 bank-year observations for France, 222
for Germany, 167 for the United Kingdom, and 822 for the United
States. Table 2 lists the descriptive statistics of variables. Year dummies
are added to each of the regression models to control for the variation in
economic environment during the examination period.
247
Table 2. Descriptive Statistics of Model Variables

(Note)
France
Market value (MV)

Mean
6.5485
Standard deviation
10.3771
t-value (versus US)
20.575nnn
Contributed capital (CC)
Mean
3.5403
Standard deviation
3.6918
t-value (versus US)
2.292nn
Reserved capital (RC)
Mean
4.3479
Standard deviation
4.0168
t-value (versus US)
9.737nnn
Net interest income (NII)
Mean
1.9813
Standard deviation
1.8438
t-value (versus US)
15.829nnn
Net noninterest income (NNII)
Mean
0.6452
Standard deviation
1.4989
t-value (versus US)
11.533nnn
Other net income (ONI)
Mean
0.2001
Standard deviation
0.5630
t-value (versus US)
3.3nnn
Germany
UK
US
12.0083
11.5378
14.585nnn
39.5418
37.5563
2.680nnn
30.9732
30.2702
6.0511
5.0247
4.647nnn
5.2445
4.1929
2.662nnn
4.2014
5.8254
3.0345
3.9305
12.398nnn
11.6244
12.1004
3.672nnn
7.8950
8.3475
2.4770
2.2628
10.893nnn
6.8290
5.5222
4.416nnn
4.7667
4.1556
2.9579
2.7321
4.518nnn
1.9143
2.0520
0.1953
0.6745
4.938nnn
0.0834
0.4468
1.5458
2.1514
2.255nn
0.1370
0.5119
1.399
nn
and nnnDenote statistical signicance at level of 5% and 1%, respectively.
Note
All variables are scaled by square root of assets.
t-value is calculated for France, Germany and UK, respectively, as compared with US.
Scaling by the squared root of total assets makes it possible to

statistically compare market value, capital and earnings components
across the four countries. Market value is higher for the United Kingdom
and United States than France and Germany, reecting that equity
markets play a more (less) signicant role as a source of nancing for
commercial banks in UK and US (France and Germany). Banks in the
four countries report positive interest margin (NII), reecting the
improving business operating environment during the examination
period. Commercial banks in the United Kingdom post highest interest
income, followed by those in the United States and Germany. The
negative NNII is due to the deduction from non-interest revenue of
salary and benets, a major operating expense incurred by commercial
banks. The last earnings component, ONI represents the scope of income
from other non-recurring activities, subject to cross-country bank
regulations.
248
3.2 Regression Results

The Model 1 regression results for the between- and within-group tests
are reported in panels A and B of Table 3, respectively. The highadjusted R2 for both tests indicates that the universal implementation of
the Basle Accord results in a signicant association between market
valuation and equity capital for capital adequacy of commercial banks
across the four countries. Both the coecients of CC and RC in panel A
(B) are positively signicant for the shareholder-oriented system (the
US), showing the importance of Tier 1 and Tier 2 capital adequacy in the
market valuation of commercial banks in shareholder-oriented system
(the US). The greater weight of the coecient estimate for RC, which
Table 3. Regression Model 1 Results

Panel A: system model
F-Value 5 400.043
Variable
Coecient
Constant
CC
RC
D
CC D
RC D
1.491
1.575
2.546
6.490
0.179
1.249
Signicance 5 .000
SE
t-statistic
1.283
0.076
0.048
1.064
0.153
0.156
1.162
20.633
53.256
6.099
1.170
7.998
Adjusted R2 5 0.789
Signicance
.245
.000
.000
.000
.242
.000
D 5 system dummy; 0 if shareholder-oriented, 1 if creditor-oriented.
Panel B: country model

F Value 5 289.976
Variables
Coecient
Constant
CC
RC
D1
D2
D3
CC D1
CC D2
CC D3
RC D1
RC D2
RC D3
1.152
1.582
2.628
7.845
3.465
0.229
0.377
0.339
0.100
1.137
1.236
0.223
Signicance 5 .000
SE
t-statistic
1.302
0.079
0.056
1.325
1.533
1.764
0.222
0.210
0.308
0.204
0.260
0.117
0.885
20.145
47.135
5.919
2.261
0.130
1.697
1.612
0.323
5.585
4.750
1.903
Adjusted R2 5 0.792
Signicance
.376
.000
.000
.000
.024
.897
.090
.107
.746
.000
.000
.057
Dependent variable: market value of equity; CC 5 contributed capital; RC 5 reserved capital.

D 5 country dummy; D1 5 1 if France; D2 5 1 if Germany; D3 5 1 if the UK.
249
constitutes retained earnings and other reserves, represents future growth

prospect for commercial banks in shareholder-oriented system (the US).
In panel A, the coecient for CC D is negative but not signicant,
and that for RC D is negative and also signicant. This result indicates
that there is (no) signicant dierence in the composition of Tier 2 (1)
capital between the shareholder- and creditor-oriented systems. This
signicant dierence in RC is explainable by their dierent capital
adequacy requirements. Commercial banks in France and Germany
have greater exibility to include xed asset revaluation reserves, investment in other nancial institutions, undisclosed reserves and hidden
revaluation reserves as asset composition for meeting Tier 2 capital
adequacy (Table 1, panel A). Consequently, the markets respond to these
assets, which carry higher uncertainty and less predictable value, more as
capital management tool rather than economic benet.
Test results in Panel B further show that within the shareholderoriented system, the RC D for the United Kingdom is signicantly
dierent from that of the United States, because commercial banks in the
United Kingdom, like France, report a higher level of RC than those in
the United States as they are allowed to include more items for
regulatory capital (Table 1, Panel A), and this dissimilarity in banking
regulation leads to signicant dierence in information content of capital
adequacy between banks in the United Kingdom and the United States.
Taken together, these results rst corroborate the literature that legal
system has a primary eect on the properties of accounting numbers of
rms (e.g., Ball et al., 2000). Second, they provide further evidence that
banking regulations also plays a signicant role in the value relevance for
the components of bank capital for meeting capital requirements. The
empirical ndings support H1.
It is of interest to note that the regression results of Model 1 are
opposite to those of comparative studies based on industrial/commercial
rms, which usually report greater weight for book value of rms in
creditors- than in shareholders-oriented countries. Assuming the same
degree of market eciency and motivations for reporting opportunism,
shareholders-oriented system and more stringent banking regulations
lead to closer scrutiny of commercial banks net asset components. The
information content of regulatory capital components for US banks
signicantly improve on those for UK and French banks.
Table 4 presents the regression results for Model 2. Panel A shows that
all the three earnings components for banks under shareholder-oriented
systems are signicantly positive in relation to market value. NII is the
250

F Value 5 449.569
Variable
Coecient
Constant
NII
NNII
ONI
D
NII D
NNII D
ONI D
4.362
9.100
8.400
1.732
3.560
3.074
5.008
1.385
Signicance 5 .000
SE
t-statistic
1.145
0.138
0.276
0.747
0.950
0.393
0.482
1.216
3.811
65.900
30.436
2.307
3.747
7.824
10.393
1.139
Adjusted R2 5 0.827
Signicance
.000
.000
.000
.021
.000
.000
.000
.255
D 5 system dummy; 0 if shareholder-oriented, 1 if creditor-oriented.

F Value 5 332.319
Variable
Coecient
Constant
NII
NNII
ONI
D1
D2
D3
NII D1
NII D2
NII D3
NNII D1
NNII D2
NNII D3
ONI D1
ONI D2
ONI D3
4.764
9.416
9.551
0.137
5.721
2.208
4.922
3.320
3.336
2.018
4.928
6.425
5.890
3.535
2.255
2.205
Signicance 5 .000
SE
t-statistic
1.132
0.149
0.297
0.920
1.144
1.296
1.529
0.495
0.568
0.343
0.614
0.651
0.716
1.483
1.829
1.754
4.209
63.044
32.168
0.149
5.002
1.705
3.220
6.712
5.871
5.879
8.031
9.868
8.230
2.384
1.233
1.257
Adjusted R2 5 0.838
Signicance
.000
.000
.000
.882
.000
.088
.001
.000
.000
.000
.000
.000
.000
.017
.218
.209
Dependent variable: market value of equity; NII 5 net interest income; NNII 5 net noninterest
income; ONI 5 other net income.
result of interest-related activities, such as lending and borrowing, which

are considered to be traditional business activities for nancial intermediaries, and historically net interest margin has been the major source
of commercial banks prot. As a result of intensied competition
triggered by deregulation of the nancial markets, NNII, which is related
to investment and service activities, has become an increasingly important source of income for commercial banks (Edwards and Mishkin,
1995). Furthermore, as NNII also includes loan loss provision, and bank
251
managers are found to use loan loss provision to signal improvement in

future cash ow prospects (Wahlen, 1994). ONI, which includes mostly
foreign currency transactions for US banks, also has a positive sign.3 The
interaction terms NII D, NNII D are signicantly negative, suggesting that these two major earnings components are less value relevant
under creditor-oriented system. ONI D, which include more reserves
and provisions for creditor-oriented banks, are insignicant.
The interaction coecients of NII D and NNII D in the country
model (Panel B) demonstrate signicant dierence in the value relevance
in NNI and NNII between France, Germany and the United Kingdom
versus the United States. This dierence is attributable to two causes.
First, commercial banks in the three countries are allowed to be engaged
in a wider range of activities than in the United States (Table 1, Panel B),
but the information content of income from each individual source is lost
in the aggregate NII and NNII. Second, more diverse banking activities
also provide ampler scope for the use of accounting accruals in earnings
management, thus diluting the information content of earnings components. The NII and NNII for France and Germany are expected to be
signicantly dierent from those of the United States because of the joint
eect of dierences in reporting requirements and permissible banking
activities. The value relevance of NII and NNII diers between the
United Kingdom and United States, both of which belong to the
shareholder-oriented system, for two possible reasons. First, Ball et al.
(2000) found the earnings quality of UK (commercial/industrial) rms
inferior to that of their US counterparts. The combination of more
exible accounting standards plus fewer operating restrictions is likely to
provide commercial banks in UK with more latitude for earning
management. An alternative explanation is that commercial banks in
the United Kingdom are supplemented by a variety of other nancial
institutions, such as building societies, mutual or cooperative banks,
rural/agricultural banks, etc. The Competition and Credit Control Act
(1971) has blurred the market segmentation between commercial banks
and these institutions in the United Kingdom. The exclusion of these de
facto banking institutions from the data set would have probably
amplied the variability of the United Kingdom sample.
In contrast to the negative sign for NII D and NNII D, ONI D
is (signicantly) positive for (France) Germany and the United Kingdom. Judging by the greatest magnitude of the coecient, it can be
interpreted that French banks make a more extensive use of ONI as a
tool to manage earnings than in the other three countries. The signicant
252
dierence in ONI (NII and NNII) between France and the United States
(the United Kingdom and United States) again provide strong evidence
of the eect of banking regulation on earnings quality in addition to
reporting system (H2).
Table 5 provides the regression result of Model 3, which test the linear
information dynamic between capital and earnings compositions (H3).
Both the system and country test results have the highest adjusted R2
among all the three models, indicating that the clean surplus model
captures the linear information dynamic missing in Models 1 and 2.
A comparison of the test results of Model 3 with those of Models 1
and 2 for all the similar items reect that the value relevance of book
value and earnings depends on whether they are assessed separately
(Models 1 and 2) or in a linear information dynamic frame (Model 3).
We rst compare Models 2 and 3 for earnings components. NII D,
NNII D and ONI D are identical at both the system and country
levels between Models 2 and 3, except for that ONI D for France is
(not) signicant in Model 2 (3). A comparison of Models 1 and 3 for
capital composition reveals that CC D is insignicantly negative at the
system level in Model 1, however, it becomes signicantly positive in
Model 3. This change occurs because in Model 1, the value relevance of
book value is estimated without reference to earnings as a source of
capital; but in Model 3, it also reects the linear information dynamic
between book value and earnings. At the country level, the most
noticeable distinction is that while RC D is signicantly dierent for
France, Germany and the United Kingdom in Model 1, it becomes
insignicant in Model 3. Such changes arise because the capital and
earnings components are segregated in Model 3, but in Model 1 the
earnings is part of capital components as being contained into RC. By
combining the three models together, we can discern the value relevance
of book value (earnings) in a clearer perspective by holding earnings
(book value) constant. In the context of commercial banks, the test
results of Model 3 can also be interpreted as the joint eects of shareholder- versus creditor-oriented system (which aects book value) and
banking regulations (which aect earnings components) on the properties of accounting information contents.4
In summary, a comparison of all the three models sheds light on the
joint eect of shareholder- versus creditor-oriented system and banking
regulations on the accounting information content of commercial banks.
Models 1 and 2 demonstrate that book value and earnings components
have higher value relevance in shareholder-oriented countries where
253

F Value 5 416.169
Variable
Coecient
Constant
CC
RC
NII
NNII
ONI
D
CC D
RC D
NII D
NNII D
ONI D
1.957
0.800
1.020
6.571
7.461
2.364
5.196
0.375
0.989
2.405
4.070
0.970
Signicance 5 .000
SE
t-statistic
1.101
0.093
0.093
0.255
0.278
0.722
0.920
0.180
0.093
0.494
0.467
1.159
1.777
8.585
10.996
25.724
26.848
3.275
5.649
2.073
10.583
4.868
8.717
.836
Adjusted R2 5 0.845
Signicance
.076
.000
.000
.000
.000
.001
.000
.038
.000
.000
.000
.403
D 5 System dummy; 0 if shareholder-oriented, 1 if creditor-oriented.

F Value 5 279.566
Variable
Coecient
Constant
CC
RC
NII
NNII
ONI
D1
D2
D3
CC D1
CC D2
CC D3
RC D1
RC D2
RC D3
NII D1
NII D2
NII D3
NNII D1
NNII D2
NNII D3
ONI D1
ONI D2
ONI D3
3.888
0.782
0.936
6.632
7.946
1.280
7.330
3.723
3.746
0.264
0.286
0.606
0.359
0.018
0.034
3.298
4.350
1.534
4.563
5.971
5.234
1.351
0.684
0.219
Signicance 5 .000
SE
t-statistic
0.591
0.105
0.117
0.359
0.353
0.913
1.164
1.310
1.556
0.227
0.318
0.330
0.311
0.292
0.203
0.995
0.999
0.622
0.815
0.717
0.740
1.541
1.788
1.731
2.052
7.473
7.992
18.459
22.504
1.401
6.298
2.843
2.407
1.163
.902
1.837
1.154
.063
.167
3.316
4.354
2.466
5.598
8.329
7.070
.877
.383
.126
Adjusted R2 5 0.852
Signicance
.040
.000
.000
.000
.000
.161
.000
.005
.016
.245
.367
.066
.249
.950
.868
.001
.000
.014
.000
.000
.000
.381
.702
.899
Dependent variable: market value of equity; CC 5 contributed capital; RC 5 reserved capital;

NII 5 net interest income; NNII 5 net noninterest income; ONI 5 other net income.
D 5 Country dummy; D1 5 1 if France; D2 5 1 if Germany; D3 5 1 if the UK.
254
banking regulations are also stricter. The test results of Model 3 show
that bank accounting information in shareholder-oriented countries are
more sensitive to linear information dynamic between book value and
earnings components than in creditor-oriented countries. For example,
both the book value and earnings components are more positive for UK
than for French and German banks in Models 1 and 2; however, the
negative implication of earnings components for book value is only
discernible for the United Kingdom in Model 3.
3.3 Ratio Analysis

Accounting ratios are commonly used as measurement of rm performance. In evaluating the nancial health and operating results of a rm,
the quality of its earnings is of particular importance to analysts. Banks
attempt to eectively manage the trade-o between risk and returns in
order to improve the overall return on equity, and their performance
(income) is determined by their eciency to earn more on their assets
(loans and investments) than they pay interest to depositors through the
nancial intermediary function. However, just as variations in the
application of GAAPs may hamper comparability and reduce quality
of earnings for domestic rms, international dierences would further
aect the value relevance of analytical ratios for assessing commercial
banks performance across countries. Table 6 presents the descriptive
statistics of several typical bank nancial and operating ratios for
France, Germany, the United Kingdom and United States.
Table 7 reports the results of two sets of univariant regression, the rst
(second) set regresses each of the bank nancial and operating ratios on
net income (market value). The net income based results displays the
statistical dierences of the ratios across the four countries. These
dierences result from banks cost function (Rose and Walken, 1986)
Table 6. Descriptive Statistics of Ratios
Mean of
Capital ratio
Loan-to-deposit ratio
Return on assets
Net interest margin
Noninterest expense to assets
Noninterest income to total income
France
Germany
UK
US
0.0919
2.2976
0.0091
0.0273
0.0379
0.2785
0.0527
0.8385
0.0005
0.0147
0.0302
0.1553
0.0890
1.8165
0.0143
0.0514
0.0491
0.2941
0.0854
0.8796
0.0127
0.0412
0.0341
0.2388
0.032
0.033
0.034
0.036
0.003
0.003
0.005
0.003
0.062
0.070
0.199
0.066
0.040
0.042
0.042
0.046
0.005
0.008
0.009
0.011
0.297
0.329
0.109
0.001
0.325
0.256
0.190
0.114
0.090
0.353
0.003
0.155
SE
0.440
0.166
0.457
0.044
0.357
0.318
0.121
0.053
Coecient
3.47
5.53
2.08
0.017
3.04
3.49
2.40
2.10
2.33
6.91
0.075
2.99
3.97
1.71
6.34
0.68
0.49
0.48
1.59
0.15
t-stat
.001
.000
.037
.986
.002
.000
.016
.036
.020
.000
.940
.003
.000
.086
.000
.496
.621
.626
.111
.875
Signicance
.120
.296
.261
.051
.303
0.763
0.091
0.164
0.017
0.883
0.794
0.195
0.581
1.623
0.299
1.14
0.095
0.514
0.393
0.035
0.039
0.812
0.203
0.227
0.032
0.227
0.444
0.199
0.071
Coecient
Dependent variables: net income and market value, scaled by square root of assets, respectively.
NIEA: noninterest expense to assets.
NIITI: noninterest income to total income.
D 5 Country dummy; D1 5 1 if France; D2 5 1 if Germany; D3 5 1 if the UK.
Capital ratio
D1
D2
D3
Loan-to-deposit
D1
D2
D3
Return on assets
D1
D2
D3
Interest Margin
D1
D2
D3
NIEA
D1
D2
D3
NIITI
D1
D2
D3
Variable
Net Income
Table 7. Univariant Analysis of Ratios
0.231
0.240
0.244
0.260
0.032
0.032
0.049
0.032
0.915
0.957
0.937
1.100
0.477
0.536
1.52
0.505
0.221
0.233
0.230
0.254
0.043
0.068
0.076
0.094
SE
9.29
1.27
3.06
0.36
1.26
1.26
2.65
1.78
17.38
5.38
15.75
2.65
7.65
8.43
0.85
0.60
13.53
4.93
5.13
1.05
6.70
9.94
6.22
1.56
t-stat
.000
.202
.002
.716
.205
.207
.008
.075
.000
.000
.000
.008
.000
.000
.392
.545
.000
.000
.000
.291
.000
.000
.000
.117
Signicance
Market Value
.327
.769
.547
.626
.117
.616
R2

255
256
and do not reect the impact of cross-country institutional factors on

their information content. The interaction terms of these ratios with
country dummies indicate the dierences in banks cost function across
the four countries. These dierences are not derived from the introduction of the country classication in the analysis. In contrast, the
signicant interactions terms in the second set of market value based
results demonstrate how institutional dierences across countries aect
the markets interpretation of the ratios.
The dierences between the two sets of univariant tests illustrate how
nancial system and banking regulations inuence the markets assessment of bank performance through ratio analysis. For example, the
mean capital ratio for France (the United States) is 0.0919 (0.0854)
(Table 6). The signicance level of the net income (market value) based
interaction term of capital ratio with France is 0.086 (0.202) (Table 7). A
comparison of the paired results suggests that the markets are indierent
to the ratio between France and the United States despite their signicant
statistical dierence. The markets indierence is attributable to the fact
that French banks have more components of capital for meeting the
capital requirements, therefore, reducing the value relevance of the
variable. Another example is the paired results for the loan-to-deposit
ratio. The means for loan-to-deposit ratio for Germany and the United
Kingdom are 0.8385 and 1.8165, respectively, compared with 0.8796 for
the United States (Table 6). While the interaction coecients of loan-todeposit for Germany and the United Kingdom are not signicant in the
net income-based regression, both become signicant in market valuebased regression, implying that the markets distinguish between the
ratios of Germany and the United Kingdom versus that of the United
States in making pricing decision because the ratio has signicantly
dierent information content in terms of loan portfolio composition and
deposit types across the countries.
Table 8 lists the results of two sets of multiple regression results for
all the ratios combined, with the rst (second) set using net income
(market value) as dependent variable. Besides the dierence between
the coecient estimates of the independent variables, the intercept
dummies for France and Germany, which are insignicant in the net
income based model, become highly signicant in the market value based
model. This change in signicance implies that, while there is no
signicant dierence in banks cost function between France and
Germany, the markets take banks national identities into account
when interpreting their ratios.
Constant
D1
D2
D3
Capital ratio
D1
D2
D3
Loan-to-deposit
D1
D2
D3
Return on assets
D1
D2
D3
Interest margin
D1
D2
D3
NIEA
D1
D2
D3
NIITI
D1
D2
Variable
SE
0.004
0.004
0.006
0.005
0.029
0.033
0.035
0.035
0.002
0.002
0.004
0.002
0.072
0.087
0.172
0.105
0.067
0.072
0.070
0.111
0.007
0.009
0.012
Coecient
0.007
0.017
0.141
0.025
0.289
0.026
1.27
0.033
0.463
0.393
0.215
0.203
0.288
0.040
0.045
0.068
0.175
0.276
0.848
0.050
0.130
0.108
0.374
2.91
0.542
0.995
0.517
0.974
2.21
6.39
0.385
2.37
1.81
7.75
1.80
2.31
1.49
0.372
2.90
0.270
17.07
0.523
0.873
0.821
3.44
0.817
t-stat
Net Income
Table 8. Multiple Regression Results of Ratios
.004
.588
.320
.605
.330
.027
.000
.701
.018
.070
.000
.072
.818
.134
.710
.004
.787
.000
.601
.383
.412
.001
.414
Signicance
0.058
0.200
0.238
0.041
0.103
0.075
0.026
0.028
1.614
1.484
0.169
0.749
1.476
0.662
1.041
0.322
0.097
0.068
0.139
0.387
0.441
0.305
0.008
0.196
0.029
0.019
0.050
Coecient
0.020
0.022
0.031
0.026
0.159
0.182
0.204
0.201
0.013
0.013
0.022
0.013
0.733
0.795
0.749
1.20
0.400
0.477
0.899
0.582
0.351
0.376
0.371
0.577
0.039
0.049
0.064
SE
2.92
4.88
4.71
1.11
1.81
1.38
0.58
0.77
5.73
5.83
5.08
5.66
19.72
14.37
17.94
8.20
1.71
1.63
5.78
5.22
4.61
4.59
0.11
2.84
0.94
0.57
1.86
t-stat
Market Value
.003
.000
.000
.264
.070
.166
.562
.442
.000
.000
.000
.000
.000
.000
.000
.000
.086
.102
.000
.000
.000
.000
.910
.004
.345
.564
.063
Signicnce

257
0.022
74.46
0.000
0.525
Coecient
0.015
SE
0.302
t-stat
.763
Signicance
0.026
374.13
0.000
0.868
Coecient
Dependent variables: net income and market value, scaled by square root of assets, respectively.
NIEA: noninterest expense to assets.
NIITA: noninterest income to total income.
D3
F Value
Signicance
Adjusted R2
Variable
Net Income
Table 8. (Continued.)
0.081
SE
0.67
t-stat
Market Value
.502
Signicnce
258
259
The (lack of) signicance of the intercept as well as slope dummies

further illustrate the impact of international dierence on the value
relevance of accounting ratios as (missing) captured in the (net income)
market value based model. The adjusted R2 for the net income (market
value) based model is 0.525 (0.868). The considerable increase in the
adjusted R2 for the market value based model provides strong evidence
that markets make signicant adjustments for cross-country variations in
accounting ratio analysis, and these adjustments substantially enhances
their value relevance.
4. Conclusion
Previous literature has studied the value relevance of accounting earnings
and book value in relation to managerial discretion based on industrial/
commercial rms. This study investigates how nancial system and
banking regulations aect international bank accounting information.
Test results provide empirical evidence that the joint eects of nancial
system and banking regulations account for, to a signicant degree,
international variation in the information content of bank earnings and
book value across France, Germany, the United Kingdom and United
States. Capital requirements have an impact on the association between
book value components and market valuation. Regulations on bank
operating activities are found to have a signicant eect on the association of equity price with earnings components. The joint eect of
nancial system and banking regulations on the linear information
dynamic for commercial banks is explainable by the objective bank
function model, which shows that earnings of the period determines the
terminal book value, thus consistent with the clean surplus approach. An
understanding of the impact of cross-country institutional dierence on
the information content of accounting variables also increases the value
relevance of analytical ratios in comparing bank performance in an
international context.
Notes
1. The central bank governors of the Group of 10 countries established the Basle
Committee on Banking Supervision.
2. The acronym CAMEL stands for capital adequacy, asset quality, management
competence, earnings stability and liquidity.
3. UK banks have more items in ONI. However, as there are more US than UK banks
in the sample, the test results may be weighted toward US banks.
260
4. The dierence between book value (CC1RC) in Models 1 and 3 can also be
statistically tested. It is (not) statistically dierent from 1 in Model 1 (3) in accordance to
the theoretical constraints of the clean surplus approach.
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Journal of International Financial Management and Accounting 19:3 2008