Accounting Discretion of Banks During a Financial Crisis

Luc Laeven
International Monetary Fund (IMF); Centre for Economic Policy Research (CEPR)

Harry Huizinga
CentER, European Banking Center (EBC), Tilburg University; Centre for Economic Policy Research (CEPR)


September 2009

IMF Working Paper No. 09/207

Abstract:
This paper shows that banks use accounting discretion to overstate the value of distressed assets. Banks' balance sheets overvalue real estate-related assets compared to the market value of these assets, especially during the U.S. mortgage crisis. Share prices of banks with large exposure to mortgage-backed securities also react favorably to recent changes in accounting rules that relax fair-value accounting, and these banks provision less for bad loans. Furthermore, distressed banks use discretion in the classification of mortgage-backed securities to inflate their books. Our results indicate that banks' balance sheets offer a distorted view of the financial health of the banks.

Keywords: Accounting, Asset management, Asset prices, Bank accounting, Bank regulations, Banks, Financial crisis, Housing prices, Investment, Liquidity management, Real estate prices

Working Paper Series