Why the New Rules on Banks’ Financial Disclosures Aren’t Strict Enough

When individual banks engage in risky behavior—such as extending credit too readily or taking on too much collateral that cannot be easily liquidated—they can quickly get into trouble. As demonstrated by the US real-estate boom and bust of the 2000s (and the savings and loan crisis of the 1980s), the problem can become systemic, spreading to financial institutions that may have interlocking agreements with other big institutions.

Bank regulators and markets are supposed to help put the brakes on overly risky behavior. But their ability to recognize that problems are brewing may be limited by the kind of information that banks put in their financial statements and disclosures, write Viral Acharya and Stephen G. Ryan—both from New York University—in their paper, “Banks’ Financial Reporting and Financial System Stability.”

The financial risk–related information that banks have traditionally reported has long been of limited use, Acharya and Ryan argue. Back in 1983, Chicago Booth’s Douglas W. Diamond and Washington University’s Philip H. Dybvig pointed out that banks’ leverage and risk were not “perfectly observable.” This year, the Basel Committee on Banking Supervision expanded risk disclosure requirements. But Acharya and Ryan suggest it didn’t go far enough. They say that there are other ways to provide early warning about leverage and risk, and other threats.

For example, current financial-reporting requirements typically call for banks to disclose risk exposure only when “it is reasonably possible that the exposure has significant effects on [a single bank’s] total assets or net income,” write Acharya and Ryan.

Citing a 2009 recommendation by Chicago Booth’s Christian Leuz, Acharya and Ryan argue that financial-reporting rules should require individual banks to better disclose their potential risks—such as those related to subprime mortgage–related assets—as those could accumulate system-wide, or spread to large banks that serve as counterparties in significant transactions.

They also note that when banks hold risky assets that are or could become illiquid and difficult to value, the banking system’s stability could be threatened. Although current standards require banks to extensively disclose certain fair-value measurements of their assets and liabilities, those measurements may not reflect the effect that a possible stress situation, such as a sudden economic downturn, could have on those balance sheet items.

To address this, Acharya and Ryan suggest expanding fair-value-measurement disclosure (at least in regulatory reporting) to include assets that would likely become illiquid or otherwise impaired in a sharp downturn or other stress scenario.

The researchers point out that although guarantees by so-called lenders of last resort (LOLRs), such as central banks, are designed to promote economic stability, they can also spur banks to engage in risky behavior that could threaten that stability, raising the specter of “moral hazard.”

For example, knowing that they’ve got backing from LOLRs could prompt banks to take on riskier loans, or encourage them to be slow to record losses on problem loans in a timely manner, reducing the ability of regulators and other outsiders to spot early warning signals. To address this, regulators could beef up existing capital requirements—by, for example, requiring banks to maintain enough capital to cover the possible illiquidity of pledged assets that would be carried on the books at a fair-value measurement, instead of at current historical values.

Or, add Acharya and Ryan, regulators could require financial institutions to gradually dispose of potentially illiquid assets while gradually recording the losses associated with them.