• Banks can be reluctant to disclose sub-par financial performance for fear of a negative market reaction
• During the 2008-2009 financial crisis, banks’ late and unreliable disclosures caused investors to lose confidence
• Measures introduced to limit financial losses during a crisis can have unforeseen consequences that actually make losses worse

Walking down the street with your eyes closed is a bad idea. Suppose you walk into a lamppost? Next thing you know, you’ve opened your eyes to find three of your teeth sprinkled on the pavement.

But how does this relate to banking?

After the 2008-2009 financial crisis, the G20 raised concerns about banks’ accounting for loan losses. Critics argued operating on an incurred loss model (assuming all loans will be repaid until evidence to the contrary is proven) delays loss recognition and corrective action. A bit like walking down the street with your eyes closed. You only realise there was an obstacle after it’s hit you, leaving you to review the evidence – be it revenue losses or empty gums.

Just as overconfidence in performance or profit can cause catastrophe, new research from Vienna University of Economics and Business (WU) reveals that the delayed handling of losses can destabilise financial systems. According to the study, many banks were reluctant to disclose their losses and critical positions, and just as reluctant to react to them.

Professor Christian Laux, of WU’s Institute for Finance, Accounting and Insurance, and his co-authors investigated banks’ disclosure and accounting for credit risks and losses. The researchers believed that being transparent about risks and losses is important for investors, but can lead to negative market reactions that worsen problems for banks.

However, Professor Laux says their study found little evidence that banks’ initial disclosures of sub-par performance were met with a strong market response or destabilised the financial system during the crisis. “Our analysis shows that banks disclosed their critical positions and possible losses very late. The evidence fits the hypothesis that unreliable and incomplete disclosures can lead to a loss of confidence that poses a threat to financial systems,” he says.

Because the disclosures came late, figures often had to be substantially revised upwards to account for continuing losses, the authors reveal, making their performance reports unreliable or sometimes incomplete, and eroding investor trust.

The authors studied 20 banks (10 based in the US and 10 in Europe) that were important in the 2008 financial crisis either because of their size, position within the financial system or public attention when they failed.

“This analysis cannot conclude that more forthcoming disclosures would have been better or could not have had detrimental effects,” Professor Laux says. “But what clearly emerges is that markets do not wait for bank disclosures when a crisis starts to unfold and market conditions deteriorate. In this situation, withholding information is unlikely to be helpful.”

The researchers also found that regulations introduced to stabilise the financial system can have the reverse impact due to unintended undesirable consequences.

According to the authors, regulatory bodies often use filters to protect banks’ regulatory capital from sudden losses. Regulatory capital, also called capital requirement, is the amount of money a bank is required to hold by its financial regulator.

The filters in question are designed to prevent banks from making risky financial agreements with the money by sifting through potential investments and, in theory, reducing the likelihood of the money whirling sharply down a plughole.

However, the researchers found these precautionary measures can incentivise banks to hold on to assets which have deteriorated in value and delay them from taking corrective actions, such as cutting dividends, reducing risk-weighted assets, and raising new capital. They explain that banks are sometimes reluctant to take corrective action because this could be viewed as a sign of weakness by investors.

The researchers’ findings that banks were late in recognising and reporting loan losses are in line with the concerns of financial regulators after the crisis, and highlight the importance of providing strong reporting incentives. They believe it was this lateness, and its effect on the reliability of disclosures, that undermined investor confidence.

“Our interpretation of the evidence is that the problem was not that investors overreacted to bank information, but that they did not have sufficiently reliable disclosures,” says Professor Laux.

The study also shows that prudential filters, even though they are introduced to protect banks’ money, can actually dampen banks’ incentives to take early corrective action when threatened by losses from their debt securities.

Professor Laux believes this fits in with established themes in banking regulation: measures introduced to limit financial damage are based on after the fact analysis of a crisis – but often have side effects that change the ways banks react to future crises in unforeseen ways.