Government support tempts banks to make risky accounting choices

It’s the quintessential economic nightmare: banks falling like dominoes. This is why, when bankruptcy comes knocking, governments tend to bail out large banks that operate globally and have ties to many other banks. Known as ‘systematically important financial institutions’ (SIFIs) – that is, banks whose failure could trigger a major financial collapse – thus take risks not only in their investments and financial products, but also in their accounting practices.

“Under this system there’s no incentive for banks to act conservatively”, says researcher Annelies Renders, who will spend the next three years studying the accounting choices of European banks. Supported by a Veni grant, she also aims to make recommendations for how to modify this risk-taking behaviour. “There’s no doubt the current crisis played a role in the decision to award this grant.”

Hot on the heels of ABN AMRO and ING, now it’s SNS’s turn. Taxpayers hardly bat an eyelid these days when governments swoop in to save banks on the eve of bankruptcy. SIFIs certainly take too many risks, for example by reselling loans or issuing them to people who can’t afford them in the first place. But less well known is the fact that large banks also take risks when it comes to their accounting choices.

Favourable balance

Since the 1990s the accounting world has seen the emergence of a phenomenon known as fair value accounting. “When a company buys a building, the cost price used to be reported on its balance sheet. The same is true for financial products that are traded on the market, such as derivatives and shares. But since the 1990s it’s been possible to report the market value instead. That’s beneficial for your balance sheet if the value of the product has increased since the purchase. And in the nineties that was usually the case”, says Renders. This meant investors could see the market value of products and therefore also their profit or loss. “The disadvantage is that if the stock markets collapse, the market prices also fall, resulting in less profit for the bank, or even a loss. Their capital ratio also goes down; that is, the minimum capital banks need to have in relation to their total assets.” To reverse that tide, in 2008 it was decided that banks could again choose to report the historical cost price on their balance sheets. “If you don’t have to report the drop in value, there’s no loss of profit and no negative effect on capital ratios. By opting for the historical cost price, the bank’s balance sheet would turn out positive and the risk of filing bankruptcy would decrease.”

180 banks

One might think that many banks would have opted for this. But Renders’s initial inventory of the choices of 180 banks in 32 European countries reveals that the majority of SIFIs did not. “Instead they continued to report the market value. That was a gamble, but they knew that if the economy were to pick up, they’d enjoy greater profits. And they weren’t running a real risk anyway, because if things were to turn bad, the state would act as guarantor – no matter what, in some cases. In this system of government support, there’s just no incentive to act conservatively.” The question is how to ensure that accounting choices do not have serious economic consequences.

The million dollar question

Besides mapping the accounting choices of banks and their short-term consequences, Renders will also address the million dollar question: ‘How can we change this?’ In Switzerland and Britain, for example, governments impose higher capital requirements on SIFIs. “That reduces the chance of bankruptcy and could influence their risk behaviour. Because if being reckless threatens their own capital buffer and the first losses are thus their own, they’re less inclined to take risks. The government only jumps in once their capital reaches a certain lower threshold. But more research is needed on whether that approach is really effective. And what it still doesn’t address is the underlying problem of government support.”

Emergency plan

In the United States, banks are required to draw up a plan to put into action if they run into financial difficulties. This involves drawing up a plan for orderly wind-down such that state support is not needed. “But it’s not clear whether this will work in practice, because drawing up a plan like that costs the bank a lot of time and money, and yet it’s not the bank that reaps the rewards of having a good plan in the case of bankruptcy. Instead, it’s the government and taxpayers – because after all, the bank then doesn’t have to be ‘saved’. So what interest does the bank have in investing in a good emergency plan?” Moreover, according to Renders some banks may be just too large and complex to be dismantled in this way, meaning that government support will continue to be needed anyway. This issue also forms part of her research.

For Renders, one thing is clear: accounting standards do not operate in a vacuum. “They can have great economic consequences, and are partly to blame for the current crisis. It’s important to keep that in mind when drawing up these standards.”

By Femke Kools

Annelies Renders is an assistant professor at the Department of Accounting and Information Management. She holds a master’s in Business Engineering and a PhD in Accounting from KU Leuven University, Belgium. Her current research interests are in the areas of financial accounting and corporate governance. The Veni grant will last for the coming three years.

Source: Maastricht University Magazine, 13 March 2013

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