Special Accounting for Banks Not Beneficial for Investors

Banks need radical bespoke accounting rules to clear the confusing fog over valuing assets held on their books, said a top official at the Bank of England, which takes over regulation of UK lenders next year.

“A distinct accounting regime for banks would be a radical departure from the past. But if we are to restore investor faith in banking sector balance sheets, nothing less than a radical rethink may be required,” Andrew Haldane, Bank’s executive director for financial stability, said. – 19 January Reuters article

One is bound to agree that, relative to many other industries, banks can pose significantly greater systemic risk. When key banks fail, they can drag the entire economy into decline, as was evidenced by the 2008 collapse of Lehman Brothers that precipitated the global financial crisis. It is also true that a core aspect of how banks make money through their intermediation roles differs from the typical business model of many other industries. Nevertheless, it is hard to see how differentiated accounting treatment for banks would benefit investors.

Despite the uniqueness of the intermediation aspect of the banking business model, on balance it is significantly more beneficial to only allow general purpose financial reporting. That’s because it allows investors to compare the risk, financial health, and economic value of firms across different industries.  Besides, the financial intermediation/lending functions of a bank are also sometimes applied by non-financial institutions, such as auto manufacturers with financial services divisions. 

General purpose accounting can allow the specific attributes of banks to be reflected through the presentation and disclosure requirements. For example, a bank’s balance sheet and income statement are considerably different from that of non-financial firms, as they reflect the unique nature of a bank’s assets, liabilities, and revenues. Similarly, disclosures provide latitude for reporting banks to reflect and communicate to investors what is unique about their business model (e.g., risk-weighted assets related information).

It would be hard to argue against any push towards generating highly informative disclosures that could better inform investors regarding specific, bespoke banking activities. Any dialogue between banks and investors aimed at enhancing risk disclosures, as proposed by the Financial Stability Board, would be highly welcome.

Business Model Accounting: A Detraction from Investor Information Needs

A key aspect of the differentiated accounting treatment often pushed by banks when changes to financial instrument accounting are under consideration is allowing banks to recognize and measure financial instruments based on their business model. The reflection of business models in measuring financial instruments means that the anticipated holding period of a financial instrument dictates whether a financial instrument is accounted for on a fair value basis.

However, this focus on business model does not really address the core information needs of investors, namely information required to understand the full range of risk that banks undertake and to allow investors to make judgments on risk-adjusted returns. Incidentally, Andrew Haldane has poignantly pointed out in another article that the crisis exposed the extent of risk taking by banks pursuing greater returns through the combination of the following activities:

• Increased leverage, both on- and off-balance sheet
• Writing deeply out of the money options (e.g., short CDS positions)
• Increased trading activities

Correspondingly, these strategies have generated a rise in balance-sheet risk, and accounting disclosures do not sufficiently shed light on these activities. That said, it is hard to picture how the exceptional accounting treatment sought by the banking fraternity would enhance transparency regarding these risk activities and overall balance-sheet risk, and allow investors to make accurate assessments of the risk-adjusted return on equity.

The reflection of business models in measuring financial instruments based on the anticipated holding of a financial instrument is also synonymous with accounting based on the managerial intent. However, managerial intent does not alter the economic value of the instrument. As evident during the recent crises, economic decline and refinancing constraints can result in forced liquidation of assets by the banks. Hence ex-ante, managers cannot enforce their intended holding period. In addition, accounting based on managerial intent simply provides banks flexibility to avoid recognizing real economic losses depending on the articulated intended holding period of these financial instruments. It is hardly surprising that the European Securities Market Authority (ESMA) had to raise concerns about the extent to which some European banks were recognizing losses related to sovereign debt exposures during the third quarter of 2011. A subset of ESMA’s concerns emanated from the failure of some banks to recognize losses related to distressed Euro-periphery state bonds, simply because such bonds had longer maturities.

Transparent Information Does Not Increase Systemic Risk of Banks

It is true that banks bear a safety and soundness imperative, and there are broader societal ramifications if these are not met and the banking system collapses. However, there is no compelling evidence reflecting how a differentiated reporting model for banking institutions would lower systemic risk or reduce the likelihood of bank runs or counterparty risk aversion when there is an economic impairment of assets. As history shows, even if banks never reported fair values, bank runs could still occur if bank assets were economically impaired beyond what had been expected by outside parties. Bank runs are usually predicated on outsiders ‘guessing the fair value’ when they realize they had previously overestimated the financial health of particular banks and, in so doing, perhaps over-panicking due to underestimating the actual fair value. On the other hand, well-informed, corrective, and fairly priced capital allocation and counterparty transacting can only occur under a framework of full transparency and understanding the actual fair value of a bank’s balance sheet on an ongoing basis. This, in turn, can lower systemic risk.

The emphasis of accounting reform should be on enhancing the prophylactic attributes of financial reporting information for all sectors, including banks. We should evaluate the utility of financial reporting information within the context of how much it is, or can be, part of an early-warning system for investors. It is also worth emphasizing that investors have significant information disadvantages relative to issuers, regulators, or auditors; therefore, investors’ need for transparent information should always be the primary reference point during the process of reforming accounting standards.