Ee Ff Y Crisis Economica

How did Financial Reporting Contribute to the Financial Crisis?

 
  Mary E. Barth Graduate School of Business Stanford University Stanford, CA, 94305 mbarth@stanford.edu. Wayne R. Landsman Kenan-Flagler Business School University of North Carolina at Chapel Hill, Chapel Hill, NC 27599 wayne_landsman@unc.edu.
 
 
  May 2010
 
  Forthcoming, European Accounting Review,2010

We appreciate comments from seminar participants at the Bank of Spain, Rob Bloomfield, Elicia Cowins, Hilary Eastman, Gavin Francis, Christian Kusi-Yeboah, Jim Leisenring, Martien Lubberink, Richard Rendleman, David Tweedie, and an anonymous reviewer. We acknowledge funding from the Center for Finance and Accounting Research at UNC-Chapel Hill and the Stanford Graduate School of BusinessCenter for Global Business and the Economy.

Electronic copy available at: http://ssrn.com/abstract=1601519

How did Financial Reporting Contribute to the Financial Crisis? Abstract We scrutinize the role financial reporting for fair values, asset securitizations, derivatives, and loan loss provisioning played in the Financial Crisis. Because banks were at the center of the Financial Crisis,we focus our discussion and analysis on the effects of financial reporting by banks. We conclude fair value accounting played little or no role in the Financial Crisis. However, transparency of information associated with asset securitizations and derivatives likely was insufficient for investors to assess properly the values and riskiness of bank assets and liabilities. Although the FASB and IASBhave taken laudable steps to improve disclosures relating to asset securitizations, in our view, the approach for accounting for securitizations in the IASB’s Exposure Draft that would require banks to recognize whatever assets and liabilities they have after the securitization is executed better reflects the underlying economics of the securitization transaction. Regarding derivatives, werecommend disclosure of more disaggregated information, disclosure of the sensitivity of derivatives’ fair values to changes in market risk variables, and implementing a risk-equivalence approach to enable investors to understand better the leverage inherent in derivatives. We also conclude that because the objectives of bank regulation and financial reporting differ, changes in financial reportingneeded to improve transparency of information provided to the capital markets likely will not be identical to changes in bank regulations needed to strengthen the stability of the banking sector. We discuss how loan loss provisioning may have contributed to the Financial Crisis through its effects on procyclicality and on the effectiveness of market discipline. Accounting standard setters and bankregulators should find some common ground. However, it is the responsibility of bank regulators, not accounting standard setters, to ensure the stability of the financial system.

Electronic copy available at: http://ssrn.com/abstract=1601519

How did Financial Reporting Contribute to the Financial Crisis? 1. Introduction The Financial Crisis that began midway through 2007 and continued throughthe end of 2008 resulted in the collapse of numerous commercial and investment banks, including several high profile institutions such as Bear Stearns, Lehman Brothers, Merrill Lynch, and Wachovia. The crisis resulted in a near systemic collapse of the banking sector, on which commercial lending activity depends. Much has been written about the causes of the crisis, as policy-makers, bankers, andacademics offer their somewhat differing insights and perspectives. Most agree the crisis started following the bursting of the housing bubble in the US. The near collapse of the financial sector has resulted in the greatest economic contraction that the US and Europe have seen since the end of the Second World War. As policy-makers work to deal with the problem, pressure is being placed on...