FASRI Round Table: Accounting Standard Setting and Bank Regulation March 23, 2011

1. FASRI Round Table:Accounting Standard Setting and Bank Regulation March 23, 2011 Robert M. Bushman Kenan-Flagler Business School University of North Carolina-Chapel Hill

2. Accounting Standard Setting and Bank Regulation: Different Objectives • Objective of financial reporting under US GAAP and IFRS: • To provide information that is useful to present and potential investors, creditors and others in making investment, credit, and similar resource allocation decisions. • Objective applies regardless of industry or whether firms in a particular industry are subject to regulation that uses financial statement information as an input. • Objectives of prudential financial regulation and supervision: • Protect small depositors by limiting the frequency and cost of bank failures. • Protect the financial system as a whole, by limiting the frequency and cost of systemic crises.

3. Some points of contention • Fair Value Accounting • Bank policy makers argue: • Fair value information lacks sufficient quality to be informative • Unrealized gains and losses in earnings makes earnings “too volatile” • FVA can generate pro-cyclical feedback effects • Loan loss provisioning • Call for standards setters to re-evaluate the incurred loss model currently used under FASB and IASB standards. • Current loan loss provisioning rules reinforce pro-cyclical effects of capital regulation due to the ex post nature of the recognition of credit losses under such rules • Argue that loan loss accounting should adopt a more forward-looking (or ex ante) orientation relative to the current ex post accounting model to dampen such pro-cyclicality.

4. Channels through Which Accounting Information Affects Economic Performance

5. Channels through Which Accounting Information Affects Economic Performance Prudential financial regulation • Direct market discipline: Influence behavior of bank managers • Indirect market discipline: Marketsprovide information that can be used: • By bank supervisors to improve control of problem banks • To limit regulatory forbearance. • Channel 5 (Stability) • Reduce pro-cyclical effects of capital regulation • Prevent runs & contagion • Limit regulatory forbearance • Tie in shadow banking system • Complement government analysis of information with that of private actors Channel 4 Market discipline by outside investors as a fundamental lever of prudential regulation 4 Public disclosure by bank supervisors Risk balance sheets 5 Disclosure about systemic interactions between institutions

6. Makes sense from the standpoint of efficiency for accounting standard setters and bank regulators to find common ground • A common refrain: • It is the responsibility of bank regulators, not accounting standard setters, to determine how to ensure the stability of the financial system • Bank regulators have the power to mandate whatever information is needed to meet the objective of prudential supervision. • However: • Even allowing for things like prudential filters, the accounting regime conditions regulatory outcomes. • The previous point can be overcome if financial accounting reports include presentations of results under multiple rules => significant complexity • If financial regulators create accounting rules distinct from GAAP, the complexity of the information environment will explode.

7. Bank Regulation & Loan Loss Provisioning • Proposals by the Financial Stability Forum (2009) and U.S. Treasury (2009) accentuate a standing debate between policy makers and accounting standard setters over loan loss accounting for banks. • Call for standards setters to re-evaluate the incurred loss model currently used under FASB and IASB standards. • Premise: Current loan loss provisioning rules reinforce pro-cyclical effects of capital regulation due to the ex post nature of the recognition of credit losses under such rules • Argue that loan loss accounting should adopt a more forward-looking (or ex ante) orientation relative to the current ex post accounting model to dampen such pro-cyclicality.

8. Financial accounting information serves many different roles • Accounting information serves many different users • inherently trades off informational needs across heterogeneous user demands to support a wide range of decision contexts and contractual arrangements • given such tradeoffs, changing accounting standards to enhance one particular role could degrade the usefulness of the accounting information set across other uses (Gjesdal 1981). • In this paper, we explore potential tradeoffs inherent in such proposals to fundamentally change the way in which banks determine loan loss provisions.

9. Loan loss provisioning is a key accounting choice for banks • Loan loss provisioning directly influences the volatility and cyclicality of bank earnings, and the information properties of banks’ financial reports with respect to reflecting changes in the risk attributes of loan portfolios. • The precise form that any forward looking provisioning regime should take is an open question; a number of alternative models have been put forth. • The extent to which any of the proposed alternatives would actually mitigate pro-cyclicality is also an open question A feature common to most such alternatives is that, relative to the existing incurred loss model, they would incorporate a broader range of information and create an expanded role for managerial discretion

10. Research Objective To exploit cross-country variation in allowable discretion in loan provisioning behavior to isolate distinct aspects of loan provisioning practices within a country that can be construed as reflecting a forward looking orientation To empirically investigate the extent to which a given aspect impedes or enhances the ability of regulators and outside investors to monitor and discipline bank risk taking. • The tension: • Increased discretion may facilitate incorporation of information about ex ante future expected losses into loan provisioning decisions and mitigate pro-cyclicality • But discretion increases potential for opportunistic accounting by managers which may degrade the transparency of banks and lead to negative consequences along other dimensions.

11. 3 measures of discretionary forward-looking provisioning • Large sample of banks from 27 countries • Control for non-discretionary determinants of loan loss provisions • Extract measures of discretion orthogonal to non-discretionary controls • Smoothing: defined as the coefficient on earnings before loan loss provisions. A higher sensitivity of loan loss provisions to current period earnings realization => more discretionary smoothing. • Forward Looking-LG: coefficient from regressing current period loan loss provisions on next year’s loan growth. Captures the extent to which current provisions anticipate the trajectory of loan growth and the higher expected loan losses associated with such growth. • Forward Looking-NPL: coefficient from regressing current period loan loss provisions on next year’s change in non-performing loans. Captures extent to which current provisions anticipate future deteriorations in the loan portfolio.

12. Estimating discretion in loan loss provisioning by country LLPitj= loan loss provision for bank i, at time t, in country j Ebllp = Earnings before taxes and LLP NPL = Change in non-performing loans LLR = Level of loan loss reserve CAP = equity capital Loan Growth = loan growth during the period Loans = Percent of the bank’s asset in the loan portfolio 1 = Smoothing 2 = Forward Looking-NPL 3 = Forward Looking-LG

13. Pooled regression using all countries and years

15. Market Discipline: Modeling intensity of outside discipline Premise: Outside disciplinary forces create pressure on banks to decrease leverage (increase capital) in response to increases in risk. In equilibrium: Assume that leverage is a linear function of risk: Captures intensity of disciplinary response to risk where

16. Does forward-lookingness weaken or enhance outside discipline of risk? Design: implies that discretion over provisioning behavior is associated with leverage being less sensitive to changes in risk.

18. Deposit Guarantee as a Put Option Merton (1977) characterizes deposit insurance as put option issued by the guarantor to equity holders with strike equal to the face value of the debt that is guaranteed. Derives closed form pricing model for deposit insurance put that is a non-linear function of volatility of bank’s assets and leverage. • The existence of this put option creates incentives for banks to shift risk onto the guarantee agency by increasing the risk of assets without simultaneously increasing capital adequately: • Insured depositors have low incentives to monitor risk taking activities of banks • Risk-shifting occurs when banks manage to increase the risk-adjusted cost of deposit insurance that deposit insurance agencies are unable to pass onto individual banks

19. Embedding Outside Discipline into Deposit Insurance Put Linear approximation to Merton(1977): The coefficients in (1) assume that leverage can be held constant as risk changes. However, with supervision and market monitoring this is not likely to hold! Outside disciplinary forces may create incentives for banks to decrease leverage in response to increases in risk. where

20. Embedding Outside Discipline into Deposit Insurance Put (1) Substitute in for D/V (2) where

21. Estimating Risk-Shifting (Duan et al., 1992) The relation between the ‘fair premium’ and risk captures the equilibrium outcome of struggle between risk-shifting banks and disciplining forces. After substitution: captures outcome of the conflict between risk-shifting incentives and disciplinary responses (3) where (+) (+)) (−) Incentives to increase risk Disciplinary Response <0 Observed Risk-Shifting Risk-shifting Incentives offset by disciplinary response

22. Estimation of IPP Drop estimated values for V (the implied market value of assets)and σV(the implied volatility of assets) into the theoretical pricing model for the value of IPP : where

23. Discretion and Risk-Shifting: Basic Research Design consistent with higher discretion increasing risk shifting

25. Capital level & the relation between discretion and risk-shifting

26. Performance & the relation between discretion and risk-shifting

27. Robustness