Researcher of the Month December
Did banks underreport losses and delay disclosures during the financial crisis?
Politicians, regulators, and pundits have criticized banks' financial reporting as a key culprit of the problem in the financial crisis 2008–2009 and have called for changes. But is the criticism really justified? What changes are necessary? In a recent study, Professor Christian Laux from the Institute for Finance, Banking and Insurance at WU (Vienna University of Economics and Business) and his co-authors examine the disclosure and recognition of losses of international banks during the financial crisis. The authors also investigate the consequences of a regulation that reduces the impact of losses on banks’ required regulatory capital. The evidence is important to guide standard setting and recent debates in bank regulation.
During the crisis, the use of fair-value accounting for financial instruments was widely criticized. Earlier work by Professor Christian Laux shows that this criticism of fair-value accounting was unjustified. In the current study, Laux and his co-authors address banks’ disclosure and recognition of credit risks and credit losses. The results of the study do not confirm the widespread fear that the disclosure of losses was a major cause of banks’ problems. Rather, it shows that many banks are reluctant to disclose losses and then equally reluctant to react to them. Overall, the evidence suggests that protecting banks from dealing with their losses involves risks for the stability of the financial system. “Regulation and accounting introduced with the aim of stabilizing the financial system can have undesirable consequences,” explains Christian Laux.
Disclosure of credit losses and risk exposures came late in the crisis
Information about credit risks and credit losses is important for investors, but it can also lead to negative market reactions and worsen problems for banks. “Our analysis shows that banks were very late to disclose their critical positions and potential losses,” Laux said. “We find little evidence that this disclosure exacerbated banks' problems or contributed to destabilizing the financial system.” Rather, the evidence fits the hypothesis that unreliable and incomplete disclosures can lead to a loss of trust, which poses a risk to the financial system.
Recognition of credit losses and bank incentives
When banks recognize credit losses on the balance sheet, this has not only an information effect, but reduces banks’ shareholder equity. The results on the recognition of credit losses are consistent with the results on disclosure. One possible reason is accounting standards that restrict banks from reporting credit losses (incurred loss model). “However, our analysis shows that in many cases, the standards would have allowed for higher and earlier loss recognitions,” Laux said. Banks’ incentives to report losses also play an important role.
Regulators often use filters to protect banks’ regulatory capital from (unrealized) fair-value losses on financial instruments. Such filters can mitigate the threat of downward spirals in the financial system, but they also reduce banks’ incentives to take early corrective actions such as reducing dividends, raising equity, or selling risky financial instruments. The authors show that this effect is important and that banks in countries with filters take less corrective actions when the market value of their assets decreases.
About Christian Laux
Christian Laux is a professor at WU’s Institute for Finance, Accounting and Insurance. He earned his doctorate from Goethe University Frankfurt and his venia docendi from the University of Mannheim. Before coming to WU, Christian Laux was a professor at Goethe University Frankfurt. He has spent time as a visiting researcher at Harvard University, the London School of Economics, the Wharton School of the University of Pennsylvania, and the University of Chicago Booth School of Business. In his research, Christian Laux investigates the role of incentive and information problems in the design of financial and insurance contracts, managerial incentives, and accounting systems. In his current work, Christian Laux is focusing on the role of accounting and regulation for the stability of financial systems and the behavior of banks. His work has been published in leading international journals, including the Journal of Financial Economics, Review of Finance, the Journal of Accounting Research, The Accounting Review, Accounting, Organization and Society, Management Science, Rand Journal of Economics, and the Journal of Economic Perspectives. Christian Laux is a member of the editorial and advisory review board of The Accounting Review and the Scientific Committee of the UniCredit Foundation. He has also been a member of the Executive Committee of the European Finance Association.