14 May 2019

ECGI: Accounting for financial stability - lessons from the financial crisis and future challenges

Authors argue that lack of disclosure and delayed loss recognition seem to have been bigger problems than the converse. Moreover, bank regulation intended to improve financial stability appears to have had unintended consequences through its interactions with bank accounting.

The 2008 financial crisis set off a major debate about the role of accounting for financial stability. Politicians, policymakers and commentators were quick to point to fair-value or mark-to-market accounting (FVA) – the practice to recognizing assets at market prices – as a culprit. The claim was that FVA exacerbated the crisis by facilitating excessive leverage in booms and leading to contagion and downward spirals in busts. Later, the G20 raised concerns about the accounting treatment of banks’ loan losses and the incurred loss model, arguing it delays loss recognition and corrective actions by banks. After proposed changes in Basel III, there is now also an ongoing debate on the role of shieling regulatory capital from fair value changes of certain assets by implementing prudential filters.

First, authors analyze the link between bank disclosures and financial stability. While regulators often stress the importance for market discipline, investors might also overreact to negative news in a crisis, triggering bank runs. Authors find that banks’ disclosures about their exposures came late and, looking at CDS spreads, they find little evidence that these disclosures set off problems or destabilized banks. Instead, it seems that poor and unreliable disclosures by the banks led to an erosion of trust, which based on their review and analysis likely was a bigger problem than the overreaction to bad news.

Second, they analyze the timing and magnitude of banks’ loan impairments in the crisis. In contrast to disclosures, impairments have direct consequences for regulatory capital and contracts (e.g., debt covenants). While impairments came late and were initially much too small, they do not find evidence that the incurred loss model “constrained” banks’ loss recognition. Instead, a reluctance to recognize losses and weak enforcement are more likely explanations.

Full paper

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