Differential Pricing of the Discretionary and Nondiscretionary Components of Loan Fair Values

Using a sample of banks, this study examines the capital market pricing implications of discretionary and nondiscretionary components of loan fair value estimates. We conduct our analysis in two stages. First, we determine the discretionary portion of loan fair values by modeling the nondiscretionary value changes in loans using a set of informational variables that capture changes in interest rate risk and default risk. Next, we evaluate the valuation implications of the discretionary component of loan fair values. The findings suggest that the market participants behave as if they decompose loan fair values and price the discretionary component differently than the nondiscretionary component.