How Did Financial Reporting Contribute to the Financial Crisis?

In our paper, How Did Financial Reporting Contribute to the Financial Crisis? forthcoming in the European Accounting Review, we scrutinize the role that financial reporting for fair values, asset securitizations, derivatives, and loan loss provisioning played in contributing to the Financial Crisis. Because banks were at the center of the Financial Crisis, we focus our discussion and analysis on the effects of financial reporting by banks. We begin by discussing the objectives of financial reporting and bank regulation to help clarify that information standard setters require firms provide to the capital markets and information required by bank regulators for prudential supervision will not necessarily be the same. This distinction is important to understanding why financial reporting played a limited role in contributing to the Financial Crisis.

We analyze the way in which financial reporting for fair values, asset securitizations, and derivatives potentially contributed to the Financial Crisis. For each topic we summarize the financial reporting requirements of US GAAP and IFRS, offer insights into whether the information available to investors was sufficiently transparent to make appropriate judgments regarding the values and riskiness of affected bank assets and liabilities, and summarize available research evidence. Because loans comprise a large fraction of bank assets, we also discuss how loan loss provisioning may have contributed to the Financial Crisis through its effects on procyclicality and on the effectiveness of market discipline.

Our analysis leads us to conclude, as have others, that contrary to what many critics of fair value contend, fair value accounting played little or no role in the Financial Crisis. However, transparency of information associated with measurement and recognition of accounting amounts relating to, and disclosure of information about, asset securitizations and derivatives likely were insufficient for investors to assess properly the values and riskiness of affected bank assets and liabilities. The FASB and IASB have taken laudable steps to improve disclosures relating to asset securitizations by requiring enhanced disclosures, including fair values of securitized assets and liabilities and qualitative and quantitative information regarding a bank’s continuing involvement with the securitized assets, to enable market participants to assess the risks related to the assets to which the bank is exposed. However, in our view, the alternative approach for accounting for securitizations in the IASB’s Exposure Draft that would require banks to recognize whatever assets and liabilities they have after the securitization is executed better reflects the underlying economics of the securitization transaction and therefore, coupled with enhanced disclosures about derivatives, is likely to result in more transparent financial reporting.

For derivatives, our recommendations include disclosure of disaggregated information to permit investors to know which side of the contracts a bank holds and who the counterparties are, and disclosure of the sensitivity of the fair values of derivatives—as well as other financial instruments measured at fair value—to changes in relevant market risk variables. We also recommend implementing a risk-equivalence approach to enhance disclosures relating to the leverage inherent in derivatives.

Finally, we conclude that because the objectives of bank regulation differ from the objective of financial reporting, changes in financial reporting requirements to improve transparency of information provided to the capital markets likely will not be identical to the changes in bank regulations needed to strengthen the stability of the banking sector. Moreover, bank regulators have the power to require whatever information is needed to meet the objective of prudential supervision. We conclude that it makes sense from the standpoint of efficiency for accounting standard setters and bank regulators to find some common ground. However, it is the responsibility of bank regulators, not accounting standard setters, to determine how best to ensure the stability of the financial system.

The full paper is available for download here.