Anatomy of Bank Distress

The Information Content of Accounting Fundamentals

By Janko Cizel / Edward Altman / Herbert Rijken

Plan


  1. The paper
  2. The additive value of the Risk-Weighted Framework in the prediction of bank distress
  3. LR-Dashboard

How reliable is bank accounting disclosure?

Framework

Accounting discretion $\Longrightarrow$ ability to misrepresent true performance

Incentives to inflate true performance, especially in the state of financial distress.

Consequence: "jamming" of the accounting signal.

In an extreme case, the accounting signal may lose its ability to discriminate between healthy and unhealthy institutions.

Main hypothesis


[Accounting Discretion] $$\propto$$ -[Distress Prediction Performance of Accounting Variables]

Empirical Approach


  1. Distressed Bank Event Database
  2. Drivers of bank distress.
  3. Predictive performance of accounting variables across countries
  4. [Accounting Discretion] \(\leftrightarrow\) [Predictability of Bank Distress]

Preview of the Main Results

Drivers and symptoms of bank distress:

  • regulatory capital (-)
  • asset quality (-)
  • charter value (-)
  • funding costs (+)

Information content of accounting fundamentals


  1. Large cross-country variation in the bank distress classification performance.
  2. At the country level, accounting fundamentals reported in the pre-crisis years of 2006 and 2007, fail to explain the 2007-10 aggregate incidence of bank distress across countries.

[Accounting Discretion] \(\leftrightarrow\) [Predictability of Bank Distress]


  • Better classification performance of accounting variables in countries with strong disclosure laws or with more stringent enforcement of the existing laws.

Literature


  1. Bank distress prediction during the recent financial crisis
    • E.g. Betz, Oprica, Peltonen, and Sarlin (2014); Cipollini and Fiordelisi (2012); Cihak and Poghosyan (2009)
  2. Information value of accounting disclosure
    • Healy and Palepu (2001); Beyer, Cohen, Lys, and Walther (2010); Altman, Gande, and Saunders (2010)
  3. Accounting discretion and the informativeness of accounting signals
    • Beaver, Correia, and McNichols (2012)

Bank Distress During 2007-12

Bank Distress Events

  • Bank closure:
    • Charter of the bank is revoked.
    • Includes: liquidations, court bankruptcies, regulatory receiverships, distressed mergers (mergers, in which the acquired entity's regulatory Tier 1 capital ratio falls below the Basel II threshold of 6% prior to the merger).
    • Source:FDIC, Bankscope, SNL Financial, LexisNexis.
  • Open-bank resolution:
    • Charter of the bank is preserved, and the institution continues to operate as the independent entity.
    • Includes: government bailout (e.g. investment in bank capital), coupled with a set of measures to improve the long-term viability of the bank (e.g. reallocation of the toxic assets to a bad bank).
    • Source in U.S.: bank equity infusions under the Capital Assistance Program (CAP) of TARP.
    • Source in Europe: State Aid cases from the European Commission.

Sample

  1. U.S. and 15 Western European countries
  2. Balance sheet data from Bankscope
  3. Bank types: (1) bank holding companies, (2) commercial banks, (3) cooperative banks, (4) mortgage banks, and (5) savings banks.
  4. Accounting figures at the highest level of conolidation.
  5. Selection of accounting fundamentals: representative variables from the CAMEL dimensions
    • Capital adequacy, Asset quality, Management quality, Earnings, Liquidity, and Sensitivity to market risk

Drivers and Symptoms of Bank Distress

How do distressed banks differ from their non-distressed counterparts in the years leading to distress?


$$ y_{ict} = \alpha_{ct} + \sum_{j = 0}^n \phi_{j} f^j_{ict} + \epsilon_{ict}$$

Multivariate Model of Bank Distress

$$ Pr(\text{Distressed}_{ict} = 1) = \text{Logit}(\alpha_{ct} + x_{ict}'\theta + \epsilon_{ict} )$$

Information Content of Bank Accounting Across Countries

How informative are bank accounting fundamentals in identifying distressed banks within countries?

The informativeness of a model is measured by the area under the ROC curve.

How informative are the pre-crisis bank accounting figures in explaining the aggregate incidence of bank distress across countries during 2007-10?

y ~ country-specific asset share of distressed banks (% of total banking assets in 2008)

Accounting Discretion and the Informativeness of Bank Accounting Signals

Predictability of bank distress by accounting fundamentals varies substantially across countries.

Bank management has capacity and incentives to exercise accounting discretion in order to report inaccurate information.

Bank disclosure standards and their enforcement by regulators provide a constraint on accounting discretion and on their information revelation incentives.

Bank disclosures standards and stringness of their implementation = proxy of accounting discretion

Measurement of Bank Disclosure Standards and Their Enforcement by the Regulators

  • Country-specific bank disclosure quality from the database of Barth, Caprio, and Levine (2013).
    • more than 50 different indices from the quadrennial World Bank surveys covering 180 countries since 1999.

For each index, higher values of the index correspond to either better disclosure standards, or a more stringent implementation of the standards by the regulator.

Test 1: Bank Disclosure Quality and Accounting Information Content in a Cross-Section of Banks

Hypothesis: Given a cross section of banks in country $c$ at time $t$, the marginal impact of an accounting fundamental, $x$, on the probability of bank distress, increases with the value of the regulatory disclosure index, $R$.

That is: performance of an accounting fundamental in classifying banks within a country is greatest in countries with stringent disclosure laws or the enforcement thereof.

Measure the information of content of an accounting fundamental, $x$, as the absolute magnitude of the marginal impact of $x$ on the probability that a bank becomes distressed 1 year in the future, within a cross section of banks in country $c$ at time $t$:
$$$$ $$ INFO_{ct}(x) =\Bigg|\Bigg| \left. \frac{\partial Pr(\text{Distressed}_{ict} = 1)}{\partial x_{ict}} \right|_{\text{c,t fixed}} \Bigg|\Bigg|$$

The hypothesis can be restated as: $$$$ $$INFO_{ct}(x)\Bigg|_{\substack{\\c\in\text{Good Disclosure Country}}} > INFO_{ct}(x)\Bigg|_{\substack{\\c\in\text{Bad Disclosure Country}}} \geq 0$$

$$Pr(D_{ict} = 1) = \text{Logit}(\alpha_{ct} + \theta_1 * x_{ict} + \theta_2 * R_{ct} * x_{ict} + \epsilon_{ict} )$$

Test 2: Bank Disclosure Quality and Accounting Information Content. Within-Firm Evidence

Does a time series of an accounting signal produced by a distressed bank anticipates the bank's eventual failure?

A signal is judged as informative if its reported value immediately before the distress period is distinct from its value in the periods further from the distress event.

$$ Pr(D_{ict} = 1) = \text{Logit}(\alpha_{i} + \theta_1 * x_{ict} + \theta_2 * R_{ct} * x_{ict} + \epsilon_{ict} )$$

On the additive value of Risk-Weighted framework in measuring bank capital

\begin{align} RWCR & = \frac{\text{Tier 1 Capital}}{\text{RWA}} \\ &=\frac{\text{Tier 1 Capital}}{\text{[Risk-Insensitive Exposure Measure]}}\frac{\text{[Risk-Insensitive Exposure Measure]}}{\text{RWA}} \\ & = [\text{Leverage Ratio}] * 1/[\text{Average Risk Weight}] \end{align}

Core Equity over Total Book Assets by Country

Tier 1 Regulatory Capital Ratios by Country

Asset Risk Weights by Country

"Leverage Ratio vs Risk Weights" Analytical Dashboard

Conclusions

  • In-depth examination of the information content of the accounting fundamentals in prediction of bank distress during the recent crisis. $$$$
  • Predictions generated by accounting-based models display a substantial cross-country variation in bank distress classification performance. $$$$
  • Pre-crisis values of accounting fundamentals, aggregated at the country level, fail to explain the 2007-10 aggregate incidence of bank distress across countries. $$$$
  • Accounting signals of bank distress tend to be stronger in countries with strong disclosure laws or with more stringent enforcement of the existing laws.

THE END

BY Janko Cizel

www.jankocizel.com