Can smarter accounting improve bank regulation?

Martin Daks | Mar 21, 2019

The Federal Reserve walks a tightrope as it tries to promote stability and growth in the United States’ financial system while also curbing excessive bank lending risk. But as the 2018 year-end bear market demonstrated, Fed moves can risk plunging markets into chaos.

New accounting standards may relieve some of the pressure on the Fed, according to University of California at San Diego’s Jeremy Bertomeu, Tilburg University’s Lucas Mahieux, and Chicago Booth’s Haresh Sapra. They argue that a lighter touch from regulators—in coordination with an early-warning accounting system going into effect in December 2019—could deliver fewer shocks to the economy. 

The new accounting standards, ASU 2016-13 and IFRS 9, will require banks to use an expected-loss model to account for loans that may be about to go bad—a marked change from existing accounting regulations. Under the current, incurred-loss model, banks don’t recognize a credit loss on their financial records until it is “probable” that a loss has actually been incurred. By contrast, expected-loss models are based on estimates of cash flows that the lender does not expect to collect. An expected-loss model employs information that is less precise, and the threshold for recognizing losses would potentially be lower. Consequently, the researchers’ model, which considers regulators, banks, and passive insured depositors, indicates that an expected-loss approach would result in more loan liquidations, or write-offs.

In the long run, this would be a plus for the overall economy because it would not only reduce banks’ risk-taking behavior but also expand their capacity to originate loans, the researchers argue. This result may seem counterintuitive, but as banks become more conservative, “safe” loans are likely to make up a higher percentage of their portfolios even as banks’ write-offs of “risky” loans rise. This trend, according to the model, would in turn increase the confidence of regulators, who would be more likely to allow banks to increase leverage by extending more loans.

The incurred-loss methodology earned criticism following the 2008–09 financial crisis for the way it created a timing dichotomy between investors and others outside the company who analyzed financial statements on the one hand and the banks that issued them on the other. Analysts estimated expected credit losses using forward-looking information and accordingly devalued financial institutions before accounting losses were officially recognized. 

Similarly, financial-statement preparers expressed frustration because they could not record expected credit losses before the “probable” threshold was met. As the Financial Accounting Standards Board later acknowledged on its website, “this highlighted that the information needs of users differ from what GAAP [generally accepted accounting principles] requires.”

Accounting standard setters have noted that they are not equipped to judge the efficiency of regulators, but the researchers’ findings suggest that encouraging communication between the two bodies could lead to better intervention.