Ebook Accounting for Banks, Capital Regulation and Risk-Taking
The current banking crisis has raised much criticism of fair value accounting due to the mandatory adoption of SFAS 157 (Fair Value Measurement) in 2007 which resulted in large amounts of write-downs and recognition of credit losses in banks and financial institutions. This criticism has mainly focused on the unreliable value estimation for assets with illiquid markets and the systematic risk induced by excessive volatility under fair value accounting (Andrea et al., 2004; Landsman, 2005), and it has intensified during the current credit crunch. Many financial institutions blame fair value accounting for aggravating the financial crisis at a time where markets are extremely illiquid and proper valuation models are unavailable; some even call on FASB to reassess the new fair value standard. Advocates for fair value accounting, on the other hand, emphasize the benefits in terms of improved transparency and disclosure, promoting market discipline and providing relevant information for decision makers.
Given the ongoing debate amid the financial crisis, it is crucial to have a better understanding of the desirability of different accounting regimes for banks so as to provide guidance for policymakers and regulators in the post-crisis regulatory reform. To that end, this paper examines whether different financial reporting standards for banks provide relevant information for the prudential regulation and discipline of banks. Specifically, in a theoretical model I examine how accounting regimes affect the effectiveness of capital regulation in restricting banks’ risk-taking behaviors.
Banks have incentives to engage in excessive risk-taking as a result of high leverage, as shown by Jensen and Meckling (1976). The incentives for risk-taking are greater when banks’ investment decisions are not observable or verifiable to outsiders. Due to the nature of deposit financing, depositors are typically dispersed and uninformed small investors with deposits insured by the government, therefore they lack both the capability and incentives to monitor banks’ investment decisions. While debt holders in other industries may protect themselves through various instruments such as covenants and close monitoring, banks are subject to prudential regulation where the regulator serves as the representative of small investors (Dewatripont and Tirole, 1994). An important aspect of the current regulatory system is the explicit minimum capital requirement, which was introduced in the Basel Accords as part of the bank regulatory reform in the late 1980s in response to the Savings and Loans (S&L) crisis. By forcing banks to hold more capital, it is expected that risk-taking incentives can be reduced. The move toward market-value based accounting in banks and financial institutions has also been triggered by the S&L crisis, which in part was attributed to a lack of transparency under historical-cost based accounting (Benson et al., 1986; Kaufman, 1996). Consistent with the proposal’s recommendation, the use of current valuations among banks and financial institutions has increased over the past 20 years, with FASB’s issuance of a number of accounting standards related to fair value accounting. FASB is also advocating moving toward the comprehensive or full fair value accounting, in which all financial assets and liabilities are recorded at fair value on the balance sheet and changes in fair value recorded in earnings.
Whether or not capital requirement can effectively restrict the risk-taking depends crucially on the extent to which the measure of capital is accurate and informative. Therefore capital regulation confers an important role to accounting methods that largely determine how the net worth (capital) is measured. Three accounting regimes are analyzed in this paper: historical cost accounting (HC), lower-of-cost-or-market accounting (LCM), and fair value accounting (FV). I assume in the model that LCM and FV are equivalent when economic losses are realized; the only difference between these two arises when economic gains are realized.
The basic model in the paper follows John et al. (1991), capturing the key feature of banks’ risk-taking incentives in a simple framework. The bank chooses between a safe investment and a risky investment, where the risky investment opportunity only appears after the bank exerts certain effort ex-ante and the information about project risk is privately observable only to the bank. The bank also simultaneously decides the amount of equity capital to be issued along with the investment policy, and raises the rest of investment through deposits. I assume that the deposits are fully insured by government insurance agencies such as Federal Deposit Insurance Corporation (FDIC). The bank is somewhat myopic in that it maximizes a weighted average of the short term earnings recognized and the final expected payoff to shareholders, subject to the cost of capital regulation. Different accounting regimes determine the expected earnings to be recognized and the expected regulatory cost when the interim capital falls below the regulatory requirement.
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