Accounting Discretion of Banks During a Financial Crisis

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Abstract

This paper presents evidence of banks using accounting discretion to overstate the value of distressed assets. In particular, we show that the stock market applies far greater discounts to a bank’s real estate loans and mortgage-backed securities than are implicit in the book values of these assets, especially following the onset of the U.S. mortgage crisis. This suggests that bank balance sheets overvalue real estate related assets during economic slowdowns. Estimated discounts are smaller for distressed banks, as these banks derive relatively large benefits from the financial safety net to offset asset impairment. We also find that bank share prices, especially for banks with large exposures to mortgage-backed securities, react favorably to recent changes in accounting rules that relax fair value accounting. Banks with large exposures to mortgage-backed securities are also found to provision less for bad loans. Finally, we find that banks, and especially distressed banks, use discretion in the classification of mortgage-backed securities so as to inflate the book value of these securities. Our results provide several pieces of compelling evidence that banks’ balance sheets offer a distorted view of the financial health of the banks, especially for banks with large exposures to real estate loans and mortgage-backed securities, and suggest that recent changes that relax fair value accounting may further distort this picture.
Original languageEnglish
Place of PublicationTilburg
PublisherFinance
Number of pages58
Volume2009-58
Publication statusPublished - 2009

Publication series

NameCentER Discussion Paper
Volume2009-58

Keywords

  • bank regulation
  • accounting standards
  • fair value accounting
  • real estate loans
  • mortgage-backed securities
  • financial crisis

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  • Cite this

    Huizinga, H. P., & Laeven, L. (2009). Accounting Discretion of Banks During a Financial Crisis. (CentER Discussion Paper; Vol. 2009-58). Finance.