Debt and risk overhangs are positively correlated across banks. Therefore, the financial system’s collective excessive leverage and holdings in potentially illiquid assets intensify instability. Regulators, financial policymakers, and investors must consider the combined exposures of the banking sector, and they need timely and complete information to assess potential distress and to design systems that promote stability. The authors present financial reporting issues that affect banks’ capital requirements and economic stability.

Controversy exists among policymakers, accounting standards boards, and researchers about the purpose of financial accounting and the impact of different accounting standards on bank debt and risk-overhang problems. Banks have “perverse incentives” to take on risky assets, hold potentially illiquid assets, and remain undercapitalized. The authors suggest that fair-value accounting and expected provisioning of loan losses provide early warnings of the deterioration of economic conditions.

The authors make recommendations for financial accounting standard-setters and financial system policymakers. They suggest that regulators, who possess extensive bank-specific expertise, should take the lead in overcoming challenges caused by risk-concentrated and cycle-contingent exposures. Because of the system-wide accumulated risk exposure, early-warning systems are needed, with continuous monitoring to stay abreast of developments in new classes of risk exposure.

The authors also recommend more extensive risk disclosures of interests that can become illiquid in stress scenarios, such as off-balance-sheet loan commitments and tail risks created by credit and liquidity support of securitization conduits. Standardized and detailed disclosure is necessary for a financial stability overseer to develop and conduct stress tests based on the financial system’s aggregate exposures. The authors warn that central banks, which provide liquidity for pledged problem assets, exacerbate instability by allowing banks to keep problem assets and excessive short-term debt on their balance sheets.

The authors summarize existing research on the effects of banks’ financial accounting on financial system stability. Financial reporting issues that may affect stability—and that should be understood by regulators and investors—include the following:

• The advantages and disadvantages of transparency versus opacity in banks’ financial reporting
• Fair-value (more volatile income, equity, and regulatory capital) versus amortized cost accounting (income smoothing) and whether the measurement influences banks’ gambling for resurrection or other destabilizing actions
• The incurred loss (US GAAP) versus proposed expected loss model (The authors describe Spain’s requirement of dynamic provisioning of loan losses, creating buffers based on one or two past economic cycles; expected loss provisioning, although being considered by the FASB, is not currently allowed under the US GAAP conceptual framework.)
• Net (US GAAP) versus gross international accounting standards (IAS) reporting of risk-concentrated financial instruments and its impact on the regulatory capital requirements
• Inclusion (or not) of deferred tax assets in banks’ regulatory capital
• Off-balance-sheet interests (e.g., guarantees, loan commitments, and securitization entities) that are not consolidated (but banks retain difficult-to-assess downside tail risk)
• Gains on the sale of securitization assets that incentivize banks to originate more and poorer-quality securitized loans (The complex nature of carefully crafted securitizations means that banks’ retained interests are opaque and likely to be illiquid in an economic crisis.)

Banks will continue to explore ways to circumvent capital requirements. They have incentives to take on excessive debt and risk. Financial institutions are dynamic in their development of new structured products, and risks may not become apparent until times of market stress.

Regulators and accounting standard-setters tend to lag in meeting the challenges presented by new financial products or may not fully consider the composite risks posed by banks’ behavior. Regulators need to fully understand financial accounting limitations as well as the complexity and risks of securitization arrangements and other off-balance-sheet commitments, and they must be proactive in demanding the information they need to anticipate problems and protect against another financial crisis.