Fiddling with accounting rules is not going to restore the banks to health

Harry Huizinga, Luc Laeven 07 October 2009

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The current global financial crisis has reinvigorated a debate on the effectiveness of the existing accounting and regulatory frameworks for banks. Questions abound, ranging from adequate capitalisation levels of banks to the boundaries of financial regulation (see Financial Stability Forum, 2008). Part of the debate on financial reform centres around the information required from banks for effective market discipline and supervisory action. This includes not only thinking on the required level of detail on disclosure of bank assets and liabilities but also on their valuation techniques and the appropriateness of current accounting rules more generally (for a survey, see Laux and Leuz, 2009).

Accounting-linked problems

Downturns encourage banks to use accounting discretion to overstate the value of distressed assets. Accounting techniques do not generally generate large differences between the book and market value of bank assets. At times of financial crisis when asset markets become distressed, however, large differences between book and market value of assets may arise, especially when assets are carried based on historical cost. Such differences may give rise to incentives for banks to use accounting discretion to preserve their book value, for example, by using advantageous asset classifications or valuation techniques. As a consequence, discretion in accounting rules allows banks to legitimately disguise underlying balance sheet stresses. Overstated book values of bank assets may further give rise to undue regulatory forbearance.

Is the book value of banks’ capital inflated?

During the ongoing financial crisis, large differences have indeed arisen between market and book values of US banks, as their market values have sharply eroded on the expectation of major writedowns and losses on real estate related assets.

  • By the end of 2008, more than 60% of US bank holding companies had a market-to-book value of assets ratio of less than one, compared to only 8% of banks at the end of 2001.
  • Over the same period, the average ratio of Tier 1 capital to bank assets stayed constant at about 11%. The market value of bank equity thus dropped precipitously against a backdrop of virtually constant book capital.

This raises doubts about the relevance and reliability of banks’ accounting information – the two main criteria on the basis of which accounting systems are evaluated – at a time of financial crisis.

There is reason for concern. In a new paper, we show that banks use accounting discretion to systematically understate the impairment of their real-estate-related assets in an effort to preserve book capital, especially following the onset of the current financial crisis (Huizinga and Laeven, 2009). Three pieces of compelling evidence support the thesis that banks use accounting discretion to overstate the book value of capital.

1. Banks’ balance sheets overvalue real-estate-related assets compared to the market value of these assets.

We estimate significant market discounts on banks’ real estate loans starting in 2005, averaging about 10% in 2008. As the typical US bank holds over 50% of its assets in the form of real estate loans, the implicit discount in loan values goes a long way toward explaining the current depressed state of bank share prices. Investors started discounting banks’ holdings of mortgage-backed securities (MBS) in 2008. For that year, the average discount on these assets was 24%. Even MBS that are carried at fair value appear to be significantly overvalued on the books of the banks.

2. Banks with large exposure to MBS experience large excess returns when fair-value accounting rules are relaxed.

Beginning in mid-2008, there were increased pressures to grant banks more leniency to determine the fair value of illiquid assets such as thinly traded MBS to prevent these fair values from reflecting fire sale prices.

  • Correspondingly, on 10 October2008 the Financial Accounting Standards Board (FASB) clarified the allowable use of non-market information for determining the fair value of financial assets when the market for that asset is not active.
  • Subsequently, on 9 April 2009, the FASB announced a related decision to provide banks greater discretion in the use of non-market information in determining the fair value of hard-to-value assets.

As expected, the stock market on both occasions cheered the banks’ enhanced ability to maintain accounting solvency in an environment of low transaction prices for MBS. Using an event study methodology, we find that banks with large exposure to MBS experienced relatively large excess returns around both announcement dates, indicating that these banks in particular are expected to benefit from the expanded accounting discretion.

3. Banks use accounting discretion regarding the realisation of loan losses and the classification of assets to preserve book capital.

Banks have considerable discretion in the timing of their loan loss provisioning for bad loans and in the realisation of loan losses in the form of charge-offs. Thus, banks with large exposure to MBS and related losses can attempt to compensate by reducing the provisioning for bad debt. We indeed find that banks with large portfolios of MBS report relatively low rates of loan loss provisioning and loan charge-offs. We also examine banks’ choices regarding the classification of MBS as either held-to-maturity or available-for-sale, distinguishing between MBS that are guaranteed or issued by a government agency and those that are not. In 2008, the fair value of non-guaranteed MBS tended to be less than their amortised cost. This implies that banks could augment the book value of assets by classifying MBS as held-to-maturity. Indeed, we show that the share of non-guaranteed MBS that were denoted held-to-maturity increased substantially in 2008. Classification of this kind is also advantageous for banks whose share price is depressed on account of large real-estate-related exposures. Consistent with this, we find that the share of MBS kept as held-to-maturity is significantly related to both real estate loan and MBS exposures. Moreover, these relationships are stronger for low-valuation banks.

Banks’ balance sheets offer a distorted view of the financial health of the banks

Taken together, these results indicate that banks are currently using considerable accounting discretion regarding the categorisation of assets, valuation techniques, and the treatment of loan losses. Accounting discretion appears to be used by banks to soften the impact of the financial crisis on the book valuation of their assets. While some accounting discretion is unavoidable as accounting systems in part are mechanisms for firms to reveal asymmetric information to investors and other outside parties, accounting discretion entails the risk of generating highly inaccurate accounting information during downturns such as the present financial crisis. Inaccurate accounting information in the case of banks can be especially harmful, as it may lead to regulatory forbearance with concomitant risks for tax payers. In the present financial crisis, the financial statements of banks appear to overstate the book value of assets to the point of becoming misleading guides to investors and regulators alike.

Vested interests are pushing for changes that erode the value of fair value accounting. The outcomes of stress tests of major US banks conducted by the US Treasury in 2009, which calculated capital shortfalls at several major banks, are testimony to the fact that publicly available accounting information at the time provided an inadequate picture of the health of the concerned banks. Thus, the present crisis can be seen as a “stress test” of the accounting framework that reveals that book valuation need not always reflect the best estimate of asset value, especially at a time of sharp declines in market values. Accounting reforms announced so far, however, seem to go in the opposite direction of increasing the gap between book and market values. This is testimony that bank interests weigh heavily in this debate.

Disclaimer: While one of the authors of this column is a staff member of the IMF, the views expressed herein are those of the authors and should not be attributed to the IMF, its Executive Board, or its management.

References

Financial Stability Forum, (2008), “Report on Enhancing Market and Institutional Resilience”, April.

Laux, Christian and Christian Leuz, (2009), “The crisis of fair value accounting: making sense of the recent debate”, Accounting, Organizations and Society, 34(6-70: 826-834.

Huizinga, Harry and Luc Laeven, (2009), “Accounting discretion of banks during a financial crisis”, CEPR Discussion Paper 7381.

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Topics:  Financial markets

Tags:  regulation, banks, accounting rules

Professor of Economics and Chairman of the European Banking Centre, Tilburg University

Director-General of the Directorate General Research, European Central Bank and CEPR Research Fellow

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