The role of banking supervision in credit risk disclosures and loan loss provisions.
| Autor | Albuquerque, Daniela |
1 Introduction
There has been much debate concerning the recognition, measurement, and disclosure of financial assets under international accounting standards and their role in the financial crisis of 2008 (Barth & Landsman, 2010; Laux & Leuz, 2010). The media has fiercely criticised the international accounting standards for how financial instruments allowed banks to under-provision the standards' main accrual item, loan loss provisions (LLPs). This under-provisioning concealed losses from shareholders and regulators until the borrower defaulted.
Bank supervision plays a major role in the accounting quality of banks. Despite the diverging objectives of regulation and accounting, banks' practices are shaped by both frameworks. The literature (Bikker & Metzemakers, 2005; Bischof, 2009; Fonseca & Gonzalez, 2008; Gebhardt and Novotny-Farkas, 2018) has shown bank supervisors' influence on the quality of financial reporting and how country-specific circumstances with respect to the regulatory and supervisory environment affect banks' provisioning. Studies have explored two approaches to supervisory intervention in the measurement and treatment of LLPs: countries with stricter supervisory power and countries that do not intervene. In regimes with greater intervention by regulators, these studies report that supervisors require higher allowances for incurred losses beyond those allowed by the International Accounting Standard (IAS) 39--Financial Instruments: Recognition & Measurement to counteract the "too little, too late" issue. Additionally, these supervisors demand that banks provide additional disclosures on impairment losses. By contrast, non-interventionist supervisors do not interfere with loan loss provisions. The divergence of supervisory practices has always been a major issue within the European Union (EU). The Single Supervisory Mechanism (SSM) emerged as a response to the global financial crisis in 2014 and aimed to unify and improve banking supervision in Europe and, thus, to resolve the heterogeneity in supervisory practices across the EU.
The aim of this paper is to investigate the effect of the level of supervisory power on the level of disclosure of loan loss provisions and on the use of this item to smooth income. To this end, we hand-collected information from consolidated financial statements covering the period from 2012 to 2015 for 60 European banks from 15 different countries. We computed disclosure indexes in order to analyse compliance with the International Financial Reporting Standards (IFRS) and Pillar 3 of the Basel accords. In a second stage, this study analyses the influence of supervisory power on the use of LLPs to smooth income (income smoothing hypothesis).
The results of the study show that banks domiciled in countries with greater enforcement present a significantly higher level of disclosure of loan loss provisions. However, when the level of disclosure is split into IFRS 7--Financial Instruments: Disclosures and Pillar 3 disclosures, the results show that banks from countries with greater supervision only disclose more information to meet the Pillar 3 and not the IFRS 7 requirements. Therefore, we may conclude that different levels of supervision have different effects on compliance with risk disclosure requirements. Additionally, our results also confirm our second hypothesis by showing that income smoothing is lower in banks from countries with interventionist regulators. Finally, the findings provide evidence that after the launch of the SSM, there was an increase in income smoothing. This evidence is reflected in the inconsistency problems that may arise with the implementation of a supervision framework with two regulators.
This paper makes several contributions. First, the study is motivated by the lack of empirical literature on the link between banks' disclosure of LLPs and the supervisory framework. Although the literature on the relationship between recognising LLPs and the supervisory environment is extensive, the literature on the disclosure of LLPs, and in particular compliance with IFRS 7, is scarce. Bischof (2009) analyses the differences across countries of the effect of IFRS 7 on disclosure quality, but only for first time adopters. Second, this study is useful for bank supervisors as it raises awareness about their influence on financial assets through the disclosure of impairment losses and for users of financial statements as the study provides insights about the relationship between disclosure and earnings management. Third, it contributes to the debate about EU-wide inconsistency in the application of IFRS and Pillar 3 disclosure requirements that hinders the comparability of institutions' level of risk. Furthermore, this work also contributes to the debate on the possible consequences of the implementation of the SSM.
The remainder of the paper is structured as follows. Section 2 presents the background and the context of this study. In Section 3, we review the previous studies and formulate our hypotheses. We describe the sample, data, and research model in Section 4. Section 5 presents the research results, and Section 6 concludes the paper.
1.1 Background and context
The banking industry provides a unique setting to examine the role of supervisors in enforcing transparency in financial reporting for two main reasons. First, in this industry there are different entities responsible for the oversight and enforcement of accounting standards and disclosure requirements. The regulator of the national securities market and external auditors oversee the implementation of the IFRS accounting standards, while the banking supervisors focus on the enforcement of the Basel II/III regulations. To enhance and improve the consistency and comparability of these two disclosure regulations, the European Banking Authority (EBA) published guidelines on the revised requirements for Pillar 3 disclosures. Second, there are several differences in the regulatory powers of national banking supervisors. In some countries, bank regulators are even involved in setting the accounting standards (Gebhardt & Novotny-Farkas, 2018).
Regarding the recognition and measurement of LLPs, international accounting standards required publicly-traded banks to apply IAS 39 between 2005 and 2017. IAS 39 requires the recognition of LLPs based on incurred losses. Thus, firms should only recognize a loan loss if there is objective evidence of one or more events that occurred after the initial recognition of the asset that result in an impairment loss (IAS 39, paragraph 59). With regard to disclosure requirements for LLPs, banks domiciled in countries that adopted IFRS and the Basel accords are required to apply both regulations to disclose information about LLPs. IFRS 7 has been in force since 2007, and all firms that hold financial instruments should comply with it. Basel III is based on three main pillars. Under Pillar 3, bank regulators have the responsibility to ensure that banks disclose sufficient information about the allocation of capital risk (Ozili & Outa, 2017). While Pillar 3 requires more specific and technical information regarding capital requirements than IFRS 7, both regulations have many points in common regarding the disclosure of information, credit risk, liquidity risk, and market risk (Bischof, Daske, Elfers, & Hail, 2016). In order to improve stability in the banking sector and to ensure the uniform application of Basel III in all member states, the EU established a supranational banking supervisory body (the SSM) in 2014. The SSM was a compromise to apportion power between the European Central Bank (ECB) and national supervisory authorities regarding bank supervision (Gren, Howarth, & Quaglia, 2015). The establishment of the SSM reduced the flexibility of interventions by bank supervisors at the national level because it transferred to the ECB some of the national sovereignty of EU members with regard to banking supervision (1).
1.2 Literature review and hypotheses development
The literature has investigated the incremental value of additional information as a way to increase transparency and to reduce information asymmetries, not to mention as a tool for market discipline (Ahmed, Kilic, & Lobo, 2006; Balakrishnan & Ertan, 2018; Bischof, 2009). This strand of literature is even more relevant for the banking industry as the financial crisis of 2007-2008 is usually associated with its opacity because several banks took on excessive risks that were not properly disclosed (Goldstein & Sapra, 2013).
Stephanou (2010) finds that the use of market discipline for prudential purposes has been more relevant in recent years as regulators have increasingly recognized its importance for market stability. The author argues that the disclosure of adequate, timely, and reliable information is fundamental for the market as banking problems are associated with principal-agent frictions that result from information asymmetries and inadequate contract enforcement. Iren, Reichert, and Gramlich (2014) conclude that there is a positive relationship between the quantity and quality of information disclosure and the performance and stability of banks.
In the banking industry, LLPs represent one of the largest expenses and reduce banks' profit and loss and capital (Jayaraman, Schonberger, & Wu, 2019). LLPs are also relevant because they convey financial information about the future deterioration of credit risk.
The disclosure of LLPs plays a fundamental role in the market discipline framework because the cash flows and default risk of bank loans may have a significant impact on investors' estimates and therefore on stock market values (Wahlen, 1994). Based on the loan securitization market, Ertan, Loumioti, and Wittenberg-Moerman (2017) give evidence of how transparency can influence banks' credit practices and risk-taking, which leads to an improvement in the quality of securitized...
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