Bank risk taking

What is the link between reporting transparency, risk and regulation?

A New Yorker cartoon shows a father telling his teenage son, “You can learn from your own mistakes once you can pay for your own lawyer.”

In a similar vein, accounting professor Robert Bushman argues that banks should be allowed more discretion in reporting loan losses only if they have the capital to cover any potential crisis.

As the world dusted itself off after the near-implosion of the global financial system, many people – investors, bankers and taxpayers – are debating what must be changed to avoid another banking scare in the future. Many politicians and financial industry professionals argued that, before the crisis, banks didn’t have enough discretion in how they reported potential loan losses, claiming that if they’d had more discretion, they could have conveyed a more accurate assessment of the risks they were taking. Bushman’s research found that, on the contrary, banks in countries that allowed more discretion used it to create more opacity, not less.

“One of the arguments is that if you give banks discretion, they’ll use it for truth, light and justice,” Bushman said. “They’ll more accurately reflect future loan losses. They’ll create more forward-looking estimated loan losses by bringing in a broader base of information.

“We’re finding no evidence of that.”

Bushman co-authored “Accounting Discretion, Loan Loss Provisioning, and Discipline of Banks’ Risk-Taking” with Christopher Williams (UNC Kenan-Flagler PhD ’09), an accounting professor at the University of Michigan.

Using a large sample of banks located in 25 different countries, Bushman examined whether accounting discretion permitted to banks under existing regulatory regimes enhances or impedes the ability of regulators and outside investors to monitor and discipline bank risk-taking. He connected the balance sheets and income statements that banks report and linked them to the disciplinary process of overseeing banks to investigate the relation between the observed transparency of banks and the rigor of the external discipline imposed on banks’ risk-taking behavior.

He discovered that in regimes where banks are given a large amount of discretion in how they report their loan losses, the discipline over bank risk-taking is substantially weaker than in countries where banks have little discretion. And banks that have more discretion in reporting also shift more risk onto taxpayers by increasing risk without providing adequate capital, and the disciplinary force to prevent such risk-shifting in such regimes is so weak that the banks are getting away with it.

“If you’re going to argue that banks should have more discretion, you’d better be very careful,” Bushman said. “Because we just showed that the existing discretion is not being used to create sunshine. It’s blocking sunshine.”

Banks use the money they receive from shareholders, lenders and depositors to make loans and other investments. A bank’s capital is the equity it holds to protect depositors against losses. As the risk of the bank’s loan and investment portfolio increases, the bank should be required to hold more capital. That concept, known as risk-adjusted capital, is one of the most fundamental in bank regulation. Ideally, a bank should have enough capital to backstop any potential losses.

But the federal government in the U.S. and many other countries take on that backstopping role by reimbursing depositors should the bank fail. Taxpayers ultimately cover the money the government has to kick in. To mitigate the risk of such losses being dumped on taxpayers, regulators want an accurate assessment of the risk of a bank’s loan and investment portfolio, and they want that information early in the cycle while there is still time to protect against loss to taxpayers. As bank risk increases, well-informed regulators and outside lenders would pressure the bank to immediately increase its capital before loan losses occur and capital becomes difficult to come by. Proponents of giving banks discretion in reporting their loan losses say that strait-jacketing banks with an abundance of rigid reporting rules prevents banks from using their underlying judgment in making loan-loss assessments and communicating all the information they know. But that must be balanced against the propensity of banks to use discretion to hide excessive risk-taking behavior that ultimately would be imposed on taxpayers.

“We’re looking at banking and asking, how does that balancing act work?” Bushman said.

The main issue is whether accounting discretion enhances the transparency of a bank’s risk or obscures such risk. Transparency of a bank’s risk facilitates the ability of investors and regulators to impose discipline over risk-taking behavior by ensuring that the bank maintains adequate capital levels. From the perspective of the bank’s owners, capital is expensive, so a natural incentive exists to increase bank risk without commensurately increasing capital levels. And these risk-taking incentives snowball as losses loom. If a bank has insufficient equity to cover potential losses – it has no skin in the game, so to speak – and losses threaten to pull the bank under, the bank has incentive to make even riskier loans. Risky loans have a higher payoff to compensate for the greater chance that they will fail. It’s like gambling with someone else’s money, Bushman said.

“If I’m almost at the point where I have to declare bankruptcy, I’m going to gamble with the money that’s left,” he said. “If I win, I stay alive. If I lose, well, it’s not my money.”

In essence, shifting the risk to taxpayers may be a good business decision, and banks with significant discretion over loan-loss accounting may exploit it to avoid reporting excessive risk that ultimately would limit such risk-shifting. This is precisely the behavior that Bushman’s evidence documents, finding that discretion degrades the transparency of banks and thereby weakens discipline exerted over banks’ risk-shifting.

History attests to the influence of crisis and scandals as an impetus for regulatory change. Bushman’s paper shows that accounting discretion is a double-edged sword and that any changes in allowable discretion for banks must carefully balance perceived gains against potential losses in bank transparency due to opportunistic choices. “The law of unintended consequences,” he said, “is always ready to pounce.”

Key take-aways

• Banks given more accounting discretion in reporting loan losses in hopes of creating more transparency tend to use the discretion to create less transparency.
• With less transparency, regulators can’t effectively monitor risk-shifting.
• If disciplinary forces are weak, enabling banks to get away with shifting risk to taxpayers, it’s in the bank’s best interest to take more risk in hopes of reaping a higher payoff.