Financial Reporting, Financial Regulation, and Financial Stability: Evidence from German Bank Failures in 2007-2008

Abstract

We investigate three prominent German bank failures in the financial crisis of 2007-2008, IKB Deutsche Industriebank, Landesbank Sachsen, and Hypo Real Estate (HRE). The cases provide a unique setting to analyze the interrelation between financial reporting, regulation, and financial stability. All three banks were regulated based on German local GAAP, not International Financial Reporting Standards (IFRS) even though IKB and HRE were required to publish reports based on IFRS. Thus, some of the most spectacular failures early in the crisis occurred for banks that were regulated based on historical cost accounting. Regulation based on historical cost did not prevent these banks from taking on very high leverage, and it did not result in an effective cushion in the crisis.

Keywords: Mark-to-market, Fair value accounting, Financial institutions, Financial crisis, Procyclicality

JEL Classification: G15, G21, G30, M41, M42