Research paper shows that historical cost accounting alone would not have made banks safer

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05 Jul 2013

A recent research paper written by Oana M. Georgescu and Christian Laux analyses the failure of three large German banks during the financial crisis. The authors look especially at the interrelation between financial reporting and financial stability.

In their article the authors trace several "myths" on the relation between financial reporting, financial regulation, and financial stability that sprang up in connection with the financial crisis of 2007-2008. The crisis has led to a major debate about the role of accounting in general and fair value accounting in particular for financial stability. Most persistent is the claim that the recognition of banks’ assets at fair value played an important role in the demise of banks and that historical cost accounting would have resulted in less bank failures.

Looking at three German bank failures in detail leads the authors to some interesting conclusions. All three banks were regulated based on German local GAAP (HGB), not International Financial Reporting Standards (IFRS) even though two banks were required to publish reports based on IFRS. Even banks that were required to publish IFRS reports could choose to be regulated based on HGB (on basis of financial statements in accordance with HBG which needed to be submitted for this purpose but not published).

In contrast to IFRS, HGB distinguishes primarily between two reporting categories (current and fixed assets) with assets being reported in both categories at amortised cost; it is just the impairment rules that differ. So, interestingly, the authors find that “ some of the most spectacular failures of European banks occurred for banks that were regulated based on historical cost accounting.”

Although the evidence is specific, it is important for the current regulatory debate. Moreover, the examples show “that one can reasonably doubt that bank regulation and reporting based on historical cost alone would have made banks safer”. 

We thank Professor Laux for giving us permission to present the article on IAS Plus. Its full text is available through SSRN.

The article draws on two earlier articles published jointly by Professor Laux and Professor Christian Leuz:

  • The crisis of fair-value accounting: Making sense of the recent Debate published 2009 in Accounting, Organizations and Society (AOS). In this article, the authors provide a detailed and systematic discussion of the pros and cons of fair value accounting. It is available through ScienceDirect (there is a charge for downloading) and also through SSRN (free of charge). Scientific citation requires use of the version published in the AOS:
  • Did fair-value accounting contribute to the financial crisis? published 2010 in Journal of Economic Perspectives. In this article, the authors look at U.S. bank holding companies and do not find any evidence that fair value accounting contributed to the severity of the financial crisis of 2007-2008 in a major way. The article is available free of charge on the website of the American Economic Association.

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