The interplay of accounting and regulation and its impact on bank behaviour

According to a new working paper – from BIS, accounting and regulatory standards are pulling in different directions, and as a result bank risks may be misinterpreted.

Accounting rules and disclosure standards are important determinants for banks’ incentives and behaviour, and the recent financial crisis, where criticism was voiced (eg regarding the role of fair value accounting of financial assets and incurred loss provisioning of loans), is just another example of the importance and relevance of banks’ financial reporting in a regulatory and supervisory context.

In March 2013, the Basel Committee’s Research Task Force initiated a work stream that deals with aspects of the interplay of accounting and regulation and its impact on bank behaviour from a research perspective. Specifically, the work stream was tasked to “identify ways in which the interaction between accounting and regulatory rules provides incentives that affect the risk taking of financial institutions”, and it commenced research on specific aspects of loan loss provisioning, disclosure rules, fair value accounting, and prudential filters.

In summary, the results described in this report as well as the conclusions from other studies reported in Basel Committee working paper 28 suggest that both in the context of loan loss provisioning and the valuation of banks’ assets, there is a tension between backward-looking and forward-looking measurement. This observation is also consistent with the mixed picture that is given by the analytical results regarding several research questions. One conclusion is that corner solutions in one or the other direction do not seem optimal, and that an adequate mix of the two concepts may be superior. The other conclusion is that further evidence on the research questions posed is clearly needed. For example, all projects of the work stream focus on quantities, but not on prices of financial instruments (eg loan rates or yields of securities). Therefore, researchers are encouraged to further address the interplay of accounting and regulation and its impact on bank behaviour from an academic perspective.

Note: The Working Papers of the Basel Committee on Banking Supervision contain analysis carried out by experts of the Basel Committee or its working groups. They may also reflect work carried out by one or more member institutions or by its Secretariat. The subjects of the Working Papers are of topical interest to supervisors and are technical in character. The views expressed in the Working Papers are those of their authors and do not represent the official views of the Basel Committee, its member institutions or the BIS.

Author: Martin North

Martin North is the Principal of Digital Finance Analytics

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