Accounting for Financial Stability: Lessons from the Financial Crisis and Future Challenges

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 (FV) changes of certain assets by implementing prudential filters.

The evidence that emerged after the crisis shows that FVA was largely a scapegoat. The allegations against FVA were largely based on hypothetical links or models, rather than empirical facts. Our goal is to re-direct the debate on accounting issues that have received less attention, yet are central when it comes to the link between accounting, reporting and financial stability. The crisis and the evidence that has emerged since provide a number of important lessons for the regulatory debate and point to several regulatory challenges going forward.

First, we 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. We find that banks’ disclosures about their exposures came late and, looking at CDS spreads, we 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 our review and analysis likely was a bigger problem than the overreaction to bad news.

Second, we 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, we 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.

Third, we examine the role of prudential filters that reduce the impact of FV losses on regulatory capital. Filters can mitigate the threat of downward spirals, but also reduce banks’ incentives to take early corrective actions such as reducing dividends, raising equity, or selling AFS securities that deteriorated in value. We find that the association between AFS losses and banks’ corrective actions is weaker in countries where filters shield banks’ regulatory capital from FV losses, consistent with the concern that filters weaken incentives for corrective actions. Thus, the interaction between accounting and bank regulation deserves careful attention. One aspect is the tradeoff between inducing corrective actions versus downward spirals; another aspect is the classification of assets as belonging to the trading book or the banking book.

We identify several issues that deserve more attention going forward. One of these issues is the relation between accounting measurement and bank funding structure. For financial stability, a bank’s funding structure might be more important for determining the appropriate accounting measurement than management’s intent or business model, which currently determines the choice.

Overall, based on our analysis and review of the literature, 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. Thus, a number of thorny problems on the interaction of accounting and financial stability remain.