Working Paper: CEPR ID: DP7381
Authors: Harry Huizinga; Luc Laeven
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.
Keywords: Accounting Standards; Bank Regulation; Fair Value Accounting; Financial Crisis; Mortgage-Backed Securities; Real Estate Loans
JEL Codes: G14; G21
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| understatement of impairment of real estate-related assets (G32) | inflated book values (G32) |
| financial safety net (G28) | smaller estimated discounts on assets (G19) |
| large exposures to MBS (G21) | favorable reaction to changes in accounting rules (M48) |
| reporting lower loan impairments (G21) | inflated asset valuations (G19) |
| classifying MBS as held-to-maturity (G32) | carrying assets at amortized cost (G32) |
| discretion in accounting rules (G38) | systematic biases in valuations (G41) |
| banks' accounting discretion (G21) | market valuation of distressed assets (G33) |