Free Bank Failures: Risky Bonds versus Undiversified Portfolios

Almost 30% of the 872 banks established under the Free Banking System (1837–62) are considered failures, unable to reimburse noteholders for the full value of their bank notes upon closure. Lacking sufficient data, economists have focused on one of two general failure explanations: poor regulation design or undiversified bank portfolios. I test both explanations within hazard functions using Warren Weber's annual balance sheet data for almost every antebellum bank. My results suggest that free banking's bond‐secured note issue was the underlying problem, but individual banks could have avoided failure by diversifying their assets with loans and controlling their circulation.     

Self‐Fulfilling Prophecies of Failure: The Endogenous Balance Sheets of Distressed Companies

This article analyses a problem at the intersection of accounting, law, and economics: the economically efficient operation of legal arrangements for company failure is undermined because valuations of assets and liabilities become unstable once a firm is distressed. The paper draws on the three disciplines to show the pivotal role of asset and liability valuations in answering the legal question, whether the firm is insolvent, and the economic question, whether the firm should fail and its assets be redeployed to an alternative use. U.S. and U.K. evidence reveals a disconcerting indeterminacy in these processes: the probability that a firm will fail affects significantly the valuations assigned to assets and liabilities; but at the same time the valuation of assets and liabilities itself determines the probability of failure. This balance sheet endogeneity is then shown to delay economically efficient management changes under debtor‐oriented U.S. Chapter 11, and to induce unnecessary costly bankruptcy with creditor‐oriented U.K. receivership/administration. Recent cases trace this endogeneity in failures involving often controversial countermanding of huge financial claims.     

Basel II: The Route Ahead or Cul‐de‐Sac?

Despite the best efforts of regulators, banking crises throughout the world have been on the rise and proved costly both in terms of the burden on taxpayers and the effect on output. The revised Basel Accord establishes new procedures for measuring the risk of bank loans and for calculating the capital that needs to be held against these loans. But if these new rules are undoubtedly an improvement on the existing ones, their continued focus on the risk of individual loans suggests that bank regulation is heading down a cul‐de‐sac. Ideally, one would like to be able to view individual loans as parts of portfolios, with better diversified portfolios assigned lower risks and capital requirements. But because of the difficulty of measuring the risk of loan portfolios (which stems from their complicated covariance structure), the author suggests that the regulators and their constituencies would be better served by requiring more realistic valuations of loan portfolios and other bank assets. In this sense, the design of effective capital adequacy rules involves a trade‐off between developing developing more precise measures of risk, on the one hand, and improving the frequency and accuracy of asset valuations, on the other. The author urges bank regulators to focus less on refinements of risk measurement and more on efforts to incorporate fair value accounting.     

Does Fair Value Accounting Exacerbate the Procyclicality of Bank Lending?

This study investigates whether fair value accounting contributes to the procyclicality of bank lending. Using banks’ approval/denial decisions on residential mortgage applications to capture banks’ supply of credit, I find no evidence that fair value accounting has procyclical effects on bank lending over the past two business cycles. I further identify two reasons for this result. First, the main accounting item distinguishing fair value accounting from historical cost accounting—unrealized gains and losses on available‐for‐sale securities—does not affect lending decisions. Second, unrealized gains and losses on available‐for‐sale securities are not procyclical, as the risk‐free interest rate rises during some expansionary periods, resulting in unrealized losses, while the risk‐free interest rate (and sometimes the default spread) falls during some recessionary periods, resulting in unrealized gains.     

Credit Crunch Caused by Bank Failures and Self‐Selection Behavior in Lending Markets

This study investigates how bank failures affect the real economy from the lenders’ perspective. Using experimental settings of unique bank failures in Japan, this paper identifies the credit crunch effect by bank failures. The main findings are the following. First, bank failures decrease the investments of the client firms by approximately 30%. Second, the high investment growth/level firms deal with unhealthy banks. These choices generate a self‐selection bias of 30–80%. Third, there is no evidence that bank‐failure shock is related to the firms’ accessibility to other financial sources.     

Ability of accounting and audit quality variables to predict bank failure during the financial crisis

We examine the ability of selected accounting and audit quality variables measured in a period prior to the financial crisis (i.e., the four quarters of 2006), to predict banks that subsequently failed during the financial crisis. We employ two sets of samples from the US: a troubled banks sample that includes banks that failed in or after 2007 as well as banks classified as being troubled based on profitability, loan quality, and balance sheet position in 2007, and a full sample that includes all banks with available required data. Using the troubled banks sample, we identify six reliable predictors of bank failure: auditor type, auditor industry specialization, Tier 1 capital ratio, proportion of securitized loans, growth in loans, and loan mix. For the larger full sample of banks, we identify the following ten predictors of bank failure: auditor type, Tier 1 capital ratio, proportion of securitized loans, nonperforming loans, loan loss provisions, growth in commercial loans, growth in real estate loans, growth in overall loans, loan mix, and whether the bank is a public bank.     

Fair Value‐related Information in Analysts’ Decision Processes: Evidence from the Financial Crisis

We use a sample of conference calls and analyst research reports from international banks to examine how financial analysts request and communicate fair value‐related information in their valuation process. We find that analysts devote considerable attention to fair value‐related topics. Most of the conference call questions and references in research reports pertain to fair value reclassifications and fair value changes of liabilities resulting from banks’ own credit risk. The accounting impact of these one‐time effects during the financial crisis and a lack of corresponding firm disclosures help to explain the prevalence of these two topics. The content of the questions and references suggests that analysts have different motives for their interest in fair value‐related information. While some analysts adjust reported earnings for unrecognised fair value changes of reclassified assets, most of the observed analysts exclude banks’ own credit risk effects from reported earnings. Thus, the use of fair value‐related information varies substantially across analysts and across instruments.     

The Coordination Role of Stress Tests in Bank Risk‐Taking

We examine whether stress tests distort banks' risk‐taking decisions. We study a model in which a regulator may choose to rescue banks in the event of concurrent bank failures. Our analysis reveals a novel coordination role of stress tests. Disclosure of stress‐test results informs banks of the failure likelihood of other banks, which can reduce welfare by facilitating banks' coordination in risk‐taking. However, conducting stress tests also enables the regulator to more effectively intervene banks, coordinating them preemptively into taking lower risks. We find that, if the regulator has a strong incentive to bail out, stress tests improve welfare, whereas if the regulator's incentive to bail out is weak, stress tests impair welfare.     

Evaluating risk‐based capital regulation

This paper evaluates the effectiveness of risk‐based capital (RBC) regulation and challenges some evidence from the well‐known study by Haldane and Madouros (2012). We reconsider the evidence on the relationship between RBC ratios and failures of US banks from Haldane and Madouros (2012) and find their results are not robust to changes in the sample period or regression model. Using data on US commercial banks from 2000 through 2015 and an improved regression model, we compare banks’ RBC ratios and simple capital ratios as predictors of bank risk. We find simple capital ratios to be significantly better than complex RBC ratios as predictors of bank risk.     

Assessing the Impact of Fair‐Value Accounting on Financial Statement Analysis: A Data Envelopment Analysis Approach

The historical‐cost and prudence principles have guided accounting for financial investments and tangible fixed assets in many jurisdictions around the globe. This situation might change as a consequence of the increasing number of countries adopting International Financial Reporting Standards (IFRS), which, to some extent, permit accounting on a fair‐value basis. It is unclear how such a change would affect the analysis of financial statements and to what extent it could modify analysts' perceptions of companies' condition and performance. This paper attempts to shed some light on this issue by restating the financial investments and tangible fixed assets of a sample of 85 Spanish insurance companies, applying fair value instead of historical‐cost‐based valuations and by simulating analyst perception of these companies' efficiency and profitability for both sets of data using data envelopment analysis (DEA). We find that the numbers on the face of the financial statements change considerably and observe that the magnitude of these changes varies between companies and classes of assets. However, only in a few cases does a change in the valuation basis lead to a relevant change in DEA scores; within our sample, the overall assessment of companies with regard to efficiency and profitability remains largely the same under both valuation bases. These findings seem to indicate that a change from historical‐cost to fair‐value accounting could alter analyst perceptions of a limited number of companies but likely will not have a major impact on the appraisal of the majority of them.     

The Value‐relevance of Equity Accounted Carrying Amounts and Disclosed Fair Values of Listed Associates

Equity accounting is a controversial accounting treatment. Although fair value measurement represents a potential alternative measurement base, information content may be lost under a pure fair value measurement approach. This study investigates the value‐relevance of equity accounted carrying amounts and disclosed fair values of listed associates, using a sample of the largest firms listed in South Africa, Australia and the UK. The main finding is that the alternative measurement bases are incrementally value‐relevant during the sample period of 31 December 2005 to 31 December 2011, implying that equity investors do not blindly accept either measurement base. Rather, investors include their own assessment of the intrinsic value of an entity's listed associates in their valuations.     

“Too‐Small‐To‐Survive” versus “Too‐Big‐To‐Fail” banks: The two sides of the same coin

In the recent crisis, the U.S. authorities bailed out numerous banks through TARP, whilst let many others to fail as going concern entities. Even though both interventions fully protect depositors, a bail out represents an implied subsidy to shareholders, which is not yet the case with closures where creditors are not subsidised. We investigate this non‐uniform policy, demonstrating that size and not performance is the decision variable that endogenously determines one threshold below which banks are treated as TSTS by regulators and another one above which are considered to be TBTF. We, hence, provide a pair of economic rather than regulatory cut‐offs for TBTF and TSTS banks. The shareholders and the other uninsured creditors of a distressed bank are not bailed out if the bank is considered to be TSTS. We further document that the less complex a bank is, the less likely is to be bailed out and, hence, to have all of its creditors protected.     

Financial instruments,financial reporting,and financial stability

I review new empirical evidence from the recent financial crisis on the relation between financial reporting and financial stability. I draw the following conclusions: First, there is still no evidence that fair value accounting caused widespread fire sales of asset or contagion. Second, the empirical evidence suggests that accounting and regulation might have contributed to the crisis by allowing several banks to delay actions. Third, even if share prices reacted positively to the relaxation of fair value accounting rules during the crisis, the origin of the problem might be lax rules that allowed banks to run into financial and regulatory problems. Fourth, fair values can be relevant for assets that a bank intends to hold until maturity if that bank strongly relies on short-term financing. Fifth, the recognition of fair values is no substitute for information that allows investors to judge a bank's risk exposure and the validity of reported fair values.     

Agency problems,accounting slack,and banks’ response to proposed reporting of loan fair values

We investigate the determinants of bank representatives’ responses to the United States Financial Accounting Standard Board’s 2010 Exposure Draft that proposes fair value measurement for most financial instruments. Over 85% of the 2971 comment letters were received from bank representatives, with most bank-affiliated letters addressing—and opposing—one issue: fair value measurement of loans. The Exposure Draft proposes that companies report both fair value and amortized cost measures for loans; thus, the proposal should result in increased levels of loan-related information and improved financial reporting transparency. We investigate three reasons for bank representatives’ resistance. First, fair value measurement should result in less accounting slack than the current incurred-loss model for loan impairments; therefore, we propose that representatives from banks that historically utilized that slack will resist fair value measurement for loans. Second, we propose that agency problems are an important motivating factor because bank representatives reaping more private benefits from their franchises have less incentive to support increases in financial reporting transparency. Third, we test whether the most common reasons for opposition included in the comment letters are associated with negative letter writing. Our analyses support the first two determinants of bank representatives’ resistance to the Exposure Draft. Specifically, accounting slack and lower demand for accounting transparency are strongly associated with resistance to the standard. However, we find that stated reasons for resistance are not associated with letter writing. Specifically, representatives at firms with difficult to value loans and firms that mostly hold loans to maturity are no more likely to resist the standard than others. The narrow scope of bank representatives’ comments and our empirical findings suggest that bankers’ responses to the Exposure Draft may be more driven by concerns over reduced availability of accounting slack and accompanying de facto regulatory forbearance than by the conceptual arguments they offer. Our results have implications for standard setters, who must navigate special interests as they attempt to promulgate high quality accounting standards, and for users of financial statements who must consider how political forces shape generally accepted accounting principles.     

The Roles of Corporate Governance in Bank Failures during the Recent Financial Crisis

We analyze the roles of bank ownership, management, and compensation structures in bank failures during the recent financial crisis. Our results suggest that failures are strongly influenced by ownership structure: high shareholdings of lower‐level management and non‐chief executive officer (non‐CEO) higher‐level management increase failure risk significantly. In contrast, shareholdings of banks’ CEOs do not have a direct impact on bank failure. These findings suggest that high stakes in the bank induce non‐CEO managers to take high risks due to moral hazard incentives, which may result in bank failure. We identify tail risk in noninterest income as a primary risk‐taking channel of lower‐level managers.     

Determinants of discretionary fair value measurements: the case of Level 3 assets in the banking sector

The objective of our research was to respond to the call of Barth and Taylor ( 2010 ) for more research to examine the role of discretion in fair value estimates. Specifically, we investigate factors that explain banks’ accounting choices to use Level 3 valuation inputs from the fair value measurement hierarchy. Using hand‐collected data from a sample of international banks during 2009–2013, we find that incentives to use discretionary Level 3 valuation inputs, which can provide an opportunity to manage earnings, are associated with both firm‐level and country‐level determinants. Additional tests provide evidence that Level 3 ‘transfer‐in’ behaviour is related to changes in bank characteristics.     

The Real Effects of FAS 166/167 on Banks’ Mortgage Approval and Sale Decisions

We examine the real effects of FAS 166 and FAS 167 on banks’ loan‐level mortgage approval and sale decisions. Effective in 2010, these standards tightened the accounting for securitizations and consolidation of securitization entities, respectively, causing banks to recognize an estimated $811 billion of securitized assets on balance sheet. We find that banks that recognize more securitized assets exhibit larger decreases in mortgage approval rates and larger increases in mortgage sale rates. These effects significantly exceed those of banks’ off–balance sheet securitized assets, consistent with our results being driven by the consolidation of securitization entities rather than by securitization per se. We conduct tests that help rule out the financial crisis as an alternative explanation for our results. Further analyses suggest that mechanisms underlying the results include consolidating banks’ reduced regulatory capital adequacy, increased market discipline, and consequent desire not to recognize high‐risk mortgages on balance sheet.     

Liberal Fair Value Accounting in Banks: A South African Case Study

Research findings on the role of fair value accounting (FVA) in the global financial crisis suggest that FVA is not applied neutrally by banks. The results of FVA are accepted when they contribute to higher profits and are actively resisted when they lead to losses. The aim of this article is to investigate how FVA is practically applied by banks in detail. The focus is on banks as most of their assets are financial instruments and thus potentially fair valued, and banks’ behaviour is significantly influenced by their regulatory environment. The research objective is pursued by using a case study of two South African banks. One of these is the largest and most systemically important bank in the South African system and the other is on the crossover between systemic and not systemic. It is found that FVA as applied by these two banks is not neutral. Also included is a demonstration of a method to derive the unrealised portion of profit and equity, the identification of the gap between assets and liabilities at fair value as the driver of where in a banking group FVA profits and losses are realised, and the finding that the restatement of comparative figures was used to circumvent the prohibition on reclassifications into and out of the ‘designated as at fair value’ category.     

Bankers' compensation and fair value accounting

This paper examines the role of certain fair value accounting (FVA) outcomes in compensation of US bank CEOs. The use of FVA in compensation invites an agency cost—the clawback problem—if cash compensation is based on unrealized profits that may reverse in the future. At the same time FVA may be a good measure of current managerial effort and so be cash compensated. We find evidence consistent with a positive link between CEO cash bonus and fair value (FV) valuation of trading assets, managed for short-term profit, as well as (amongst banks with limited trading exposure) a positive link between CEO pay and FV valuations of available for sale (AFS) assets. We find no evidence that trading income is incrementally compensation relevant, indicating that compensation committees avoided the clawback problem for unrealized trading gains. The paper also provides evidence on the link between FVA outcomes and equity-based pay.     

The contribution of bank regulation and fair value accounting to procyclical leverage

Our analysis of how banks’ responses to asset price changes can result in procyclical leverage reveals that, for banks with a binding regulatory leverage constraint, absent differences in regulatory risk weights across assets, procyclical leverage does not occur. For banks without a binding constraint, fair value and bank regulation both can contribute to procyclical leverage. Empirical findings based on a large sample of U.S. commercial banks reveal that bank regulation explains procyclical leverage for banks relatively close to the regulatory leverage constraint and contributes to procyclical leverage for those that are not. We also show that fair value accounting does not contribute to procyclical leverage.