30 January 2015

BCBS: The interplay of accounting and regulation and its impact on bank behaviour

Many contend that accounting rules fuelled the recent global financial crisis. While there is broad consensus that accounting rules are an important determinant of bank behaviour, the specific mechanisms and their interaction with regulatory requirements are less well understood. The implications of the use of fair value accounting and the incurred loss approach of loss provisioning under

International Financial Reporting Standards (IFRS) are cases in point. Both have been criticised as contributing to a pro-cyclical behaviour in banks’ decision making, ie adding exuberance and fuelling investments in the up-turn and triggering downward spirals and throttling investments in the down-turn of the credit cycle. If these accusations are justified, then a natural question to ask is whether regulatory intervention can help to prevent a reoccurrence of such developments in the future.

From a regulatory perspective, it is crucial to understand how and to provide evidence on where accounting rules lead to undesirable incentives (additional to those incentives that are set by the regulatory capital framework) and how regulation can mitigate such unintended effects. In that direction, this paper comprises a review of the existing literature, and highlights the evidence suggested by recent studies examining the effects of accounting standards and regulation on bank behaviour. It also sketches out fruitful avenues of further research in this field.

Section 2 is concerned with fair value accounting. This is often mentioned first when one is asked for an example of an accounting aspect with high relevance from a prudential perspective. Furthermore, it has been the object of substantial work, both of theoretical and empirical nature, already well before the financial crisis unfolded.

Loan loss provisioning is addressed in Section 3. It has also been the subject of a significant amount of research, although arguably to a lesser extent than fair value accounting. Provisioning in corporate loan portfolios is an important aspect due to the high economic relevance of this portfolio for banks. Furthermore, new changes being developed by international standard setters on a more forward-looking provisioning approach lend this area a high degree of topicality.

Certain prudential filters have been introduced by regulators as a means to mitigate potential pro-cyclical effects of accounting. Their rationale and their mechanics are considered in Section 4. The scarce literature on their effects on banks’ capital and capital buffers as well as previous results related to how they can affect risk management are outlined.

Section 5 on disclosure and market discipline concludes this literature survey. It is put at the end because of its overarching nature relative to the other three research areas. After briefly considering the economic rationale for disclosure rules, the connection to market discipline and effects on bank behaviour and financial stability are discussed. Special emphasis is given afterwards to the question of when disclosure is socially optimal and to the effects of disclosing supervisory information (eg stress test results).

Full working paper

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