Accounting for Financial Stability: Bank Disclosure and Loss Recognition in the Financial Crisis

Abstract

This paper examines banks’ disclosures and loss recognition in the 2007–2009 financial crisis and identifies several core issues for the link between accounting and financial stability. We show that, going into the financial crisis, banks’ disclosures about relevant risk exposures were relatively sparse. Such disclosures came later after major concerns about banks’ exposures had arisen in markets. The recognition of loan losses also was slow and delayed relative to prevailing market expectations. Among the possible explanations for this evidence, our analysis indicates that banks’ reporting incentives played a key role, which has important implications for bank supervision and the new expected loss model for loan accounting. We also provide evidence that shielding regulatory capital from accounting losses through prudential filters can dampen banks’ incentives for corrective actions. Overall, our analysis reveals several significant challenges if accounting and financial reporting are to contribute to financial stability.

Keywords: Banks, Financial crisis, Financial stability, Disclosure, Loan loss accounting, Expected credit losses, Incurred loss model, Prudential filter, Fair value accounting

JEL Classification: G21, G22, G28, G32, G38, K22, M41, M42, M48