Research Bytes - Accounting opacity

D. MURALI | Updated on June 23, 2012

Banks which are opaque when reporting earnings may easily deny the market-relevant information when things are relatively calm. But, when a crisis strikes and stresses become more evident, the negative information revealed about opaque banks may lead to more substantial revision of market perception about their prospects with consequent impact on their stock prices, notes a recent paper titled Bank Opacity and Tail Risk during the Financial Crisis by Lee J. Cohen, Marcia Millon Cornett, Alan J. Marcus, and Hassan Tehranian ().

The authors open by noting that bank investors have long been concerned with tail risk — extreme declines in a bank’s stock price. While tail risk is determined in large part by bank financial policies such as the composition of the on- and off-balance-sheet asset and liability portfolios, the ability to assess that risk also depends on bank reporting and accounting policies, the paper explains. “For example, banks have discretion in setting the level of several key income statement accounts such as the provision for loan losses, and they can use that discretion to modulate the transparency, or opacity, of their financial reports. While accounting opacity may not directly cause tail events, it nevertheless may affect the best estimate of tail exposure conditional on observable bank attributes.”

While arguing that, like industrial firms, banks also display a positive relation between apparent earnings management and tail risk, the authors concede that such a risk typically is not evident in “normal” periods, and therefore is hard to evaluate even from long sample periods. Underlining, however, that accounting opacity seems to have a large impact on tail risk in crisis periods, the authors advise regulators to look for accounting opacity as a reliable proxy for exposure to large losses during periods of financial stress.

A subject that merits further research closer home, too.

Financial cycle

Is finance largely a sideshow to macroeconomic fluctuations? The answer could be in the negative, according to Characterising the financial cycle: don’t lose sight of the medium term! by Mathias Drehmann, Claudio Borio and Kostas Tsatsaronis ().

Stating, therefore, that any future work to model financial factors requires a better understanding of the stylised empirical regularities of the “financial cycle”, with its booms and busts possibly leading to serious financial and macroeconomic strains, the authors explore a broader range of variables that could characterise the financial cycle. The paper, based on an analysis of seven countries over the period 1960-2011, focuses on ‘medium-term frequencies,’ and financial crises, which in turn often result in major and long-lasting, if not permanent, output losses.

The foremost finding of the paper is that it is possible to identify a well defined financial cycle best characterised by the co-movement of medium-term cycles in credit and property prices. Other findings are as follows: The duration and amplitude of the financial cycle has increased since the mid-1980s; peaks in the financial cycle are closely associated with systemic banking crises; and while the financial cycle and the business cycle are different phenomena, they are related.

On the last point, the authors elaborate that while the contraction phase of the financial cycle lasts several years, business cycle recessions generally do not exceed one year. Yet, “recessions coinciding with the contraction phase of the financial cycle are especially severe, as GDP drops by around 50 per cent more than otherwise.” Importantly, the paper speaks of the “unfinished recession” phenomenon; this refers to episodes in which policy responses failing to take medium-term financial cycles into account can contain recessions in the short run but at the cost of larger recessions down the road. Cautionary read.

Published on June 23, 2012

Follow us on Telegram, Facebook, Twitter, Instagram, YouTube and Linkedin. You can also download our Android App or IOS App.

This article is closed for comments.
Please Email the Editor