We investigate bank holding companies’ (BHCs) window dressing of quarter-end financial leverage through short-term borrowings and the stock market reaction around the public release of this information. We define window dressing as a short-term deviation around quarter-end reporting dates of a financial variable from its quarterly average level. The recent financial crisis brought into focus financial institutions’ risk-taking behavior and raised concerns about whether their end-of-quarter balance sheets are fair depictions of the risk levels during the quarter. Even though the spotlight has been on the financial industry, similar incentives to mask true risk levels and the tools to achieve such objectives can exist in other industries as well.
In response to these concerns the Securities and Exchange Commission (SEC) unanimously voted on September 17, 2010 to propose rules requiring both financial and non-financial public companies to provide enhanced disclosure of short-term borrowings such as repurchase agreements (repos), federal funds purchased, and commercial paper. Appendix A summarizes the current disclosure requirements for BHCs from the Federal Reserve and the SEC as well as the SEC’s proposed rule. The SEC believes that “leverage and liquidity continue to be significant areas of focus for investors” and that short-term borrowing is a particular area of concern, for at least two reasons.
First, firms relying heavily on short term borrowings are more susceptible to fluctuations in market conditions as unfavorable movements in short-term borrowing rates and terms can make it difficult to roll over the transactions. Second, short-term borrowings pose disclosure issues because the levels of such borrowings can vary significantly during a reporting period, potentially making the end-of-period balances less representative of activities during the period, thus allowing window dressing of the ending balances.
This study provides the first large sample evidence on the window dressing of financial leverage and the stock market reaction to the public release of regulatory filings from which window dressing may be detected. Even though our analysis is based on Y-9C filings by BHCs (until now only commercial banks and BHCs are required to disclose quarterly averages of certain financial variables, see Appendix A), the implications are broader and may extend to other industries. We find evidence of significant downward window dressing of short-term borrowings, in particular, repo and federal funds liability accounts (i.e., end-of-quarter balances are systematically lower than the quarterly averages calculated on a daily or weekly basis), causing understatements in quarter-end financial leverage that appear material in a substantial fraction of the firm-quarter observations, particularly among the largest BHCs.
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Dressing of Financial Leverage
