Accounting Research Center, Booth School of Business ...€¦ · AND KRISHNA G. PALEPUt 1. Introduction Proponents of a mark-to-market accounting system for U.S. banks and thrifts

Accounting Research Center, Booth School of Business, University of Chicago

Mark-to-Market Accounting for Banks and Thrifts: Lessons from the Danish ExperienceAuthor(s): Victor L. Bernard, Robert C. Merton and Krishna G. PalepuReviewed work(s):Source: Journal of Accounting Research, Vol. 33, No. 1 (Spring, 1995), pp. 1-32Published by: Blackwell Publishing on behalf of Accounting Research Center, Booth School of Business,University of ChicagoStable URL: http://www.jstor.org/stable/2491290 .Accessed: 03/07/2012 14:22

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Journal of Accounting Research Vol. 33 No. 1 Spring 1995

Printed in US.A.

Mark-to-Market Accounting for Banks and Thrifts: Lessons from

the Danish Experience

VICTOR L. BERNARD*, ROBERT C. MERTONt, AND KRISHNA G. PALEPUt

1. Introduction

Proponents of a mark-to-market accounting system for U.S. banks and thrifts argue that the historical-cost-based financial statements now used obscure underlying economic losses, allowing troubled institutions

*University of Michigan; tHarvard University. We appreciate helpful suggestions received from participants at the Stanford Summer Camp and the Price Waterhouse Sym- posium; workshop participants at the University of Chicago, Cornell University, Indiana University, The Ohio State University, University of Michigan, University of Pittsburgh, University of Rochester, University of Southern California, Tulane University, and Univer- sity of Utah; Mary Barth, Bill Beaver, George Benston, Allen Berger, Fisher Black, Paul Healy, Jack Hughes, Robert Kaplan, Richard Leftwich, Jim Leisenring, Niels Nielsen, Finn Ostrup, Bob Ruland, Pete Wilson, and an anonymous referee.

We also appreciate the assistance of our contacts in Denmark, who shared their time and expertise with us so willingly. These include Mr. Ole Bjarrum and Mr. Lars Nielsen of Nykredit, Mr. Jesper Jesperson and Mr. Aksel Olsen of KPMG Revisionsfirmaet C. Jesper- sen, Mr. Lars Tonnesen and Mr. Birger Schmidt of the Danish Bankers Association, Mr. Kim Hartvig-Olsen of the Danish Financial SupervisoryAuthority, Mr. Jorgen Kock of Den Dan- ske Bank, and Professors Jens Elling, Merete Christiansen, Finn Ostrup, and Niels Nielson of the Copenhagen Business School. We thank Professors Dwight Crane and Bob Kaplan of the Harvard Business School, and Bob Swieringa and Jim Leisenring of the Financial Accounting Standards Board for help in conducting this research. We are grateful for financial statement data furnished by the Danish Financial Supervisory Authority, for access to the Account Database provided by Professors Elling and Christensen of the Copenhagen Business School, and for excellent research assistance by Elizabeth Andersen, Christine Botosan, Marlene Plumlee, and James Myers. We also appreciate the willingness

Copyright ?, Institute of Professional Accounting, 1995

2 JOURNAL OF ACCOUNTING RESEARCH, SPRING 1995

to continue operating without regulatory intervention.' Others, including Federal Reserve Chairman Alan Greenspan and the American Bank- ers Association, argue that practical problems of measurement render a mark-to-market accounting system unreliable.

We contribute to the debate by analyzing the Danish experience with mark-to-market accounting, which has been used in their banking sector for many years (Pozdena [1990; 1992]).2 The merits of market- value accounting must be considered in the context of a specific objective function; we focus on mark-to-market accounting as an element of the administration of the deposit-insurance system. However, much of our analysis is likely also to be relevant for shareholders of financial institutions who wish to assess the risks of insolvency and regulatory intervention.

Deposit insurance, preserves depositors' money independent of the financial health of the issuing entity, but it also leads to potential moral- hazard costs to the extent that owners are motivated to undertake high- risk investments when they have little economic capital at stake. When covered by deposit insurance, owners of troubled banks enjoy the full upside potential associated with risky assets, while the downside is borne by the deposit-insurance system or taxpayers (see Merton [1977; 1990] and Kormendi et al. [1989]).3 Merton and Bodie [1992; 1993] explain that a deposit insurer can control moral-hazard costs by (1) restricting the kinds of assets that the insured institution can hold; (2) setting a risk-based insurance premium schedule; and (3) requiring some level of net worth and monitoring its value.

The regulatory reform proposal of Benston and Kaufman [1988] and Benston et al. [1989], which was largely adopted in the 1991 Federal De-

of Mary Barth and Jim Wahlen to share certain data pertaining to U.S. banks. Finally, we are thankful for the support of the Harvard Business School and Professor Bernard is grateful for the support of the University of Michigan and the Price Waterhouse Foundation.

1 See, for example, Federal Home Loan Bank Board Annual Report to Congress [1983], Benston [1989], and White [1988; 1991a]. The Financial Institutions Reform, Recovery, and Enforcement Act of 1989 called for the U.S. Treasury Department to study the wisdom of requiring adoption of mark-to-market accounting. Financial Accounting Standards Board (FASB) Statements No. 107 and 115 take first steps toward a mark-to-market approach, by requiring companies to disclose market values of all financial assets and liabilities in financial statement footnotes, and by requiring mark-to-market accounting for all investment portfolio securities, except those to be held to maturity. Barth [1994] provides evidence that mark-to-market accounting for investment portfolios is useful in explaining banks' security price behavior.

2 We thank FASB member Robert Swierenga, who brought the existence of the Danish system to our attention.

3 Many observers of the U.S. thrift crisis point to flaws in the deposit insurance system as its most underlying cause. For a comprehensive discussion of the thrift crisis, see Ben- ston, Carhill, and Olasov [1991; 1992], Benston and Kaufman [1990], Kane [1990], Kor- mendi et al. [1989], Kohn [1991], Mayer [1990], Merton and Bodie [1992], Mishkin [1992], and White [1991 b].

MARK-TO-MARKET ACCOUNTING FOR BANKS AND THRIFTS 3

posit Insurance Corporation Improvement Act (EDICIA), relies primarily on the third approach above. Specifically, the approach involves a combination of higher capital (net worth) requirements and an aggressive policy of intervention, including possible seizure, for capital violations. The success of this approach relies on an effective monitoring system for the values of bank assets and liabilities; the monitoring, intervention, and seizure system in turn depends critically on efficient estimates of the market value of net worth, both for setting the proper levels of required capital and for avoiding losses on seized institutions.4

Whether the deposit insurance system would function more effectively with mark-to-market accounting requires consideration of both the benefits and the costs of using such a system. Because it is difficult to determine the cost-benefit trade-off of the system using theory alone, we turn to evidence from a real-world application of a mark-to- market accounting system in the Danish banking sector.

The practical issues that arise in designing and implementing a market- value accounting system are discussed in section 2. The structure of the Danish financial sector is described in section 3, and a summary of the accounting system used by Danish banks appears in section 4. Empirical results reported in section 5 show that, compared to a book-value system, the mark-to-market accounting system induces greater volatility in reported profitability of Danish banks. This may explain why small Danish banks tend to exceed minimum capital requirements. However, as long as the volatility reflects underlying economic reality, it does not imply an inefficient approach to managing the contract between Danish banks and their guarantor, the government.

Sections 6 and 7 summarize tests of the reliability of market-value estimates by Danish banks. There is some evidence of earnings management, supporting concerns that mark-to-market accounting systems are potentially vulnerable to manipulation. However, there is no reliable evidence that the mark-to-market numbers are managed so as to avoid regulatory capital constraints. There are, moreover, indications that the Danish mark-to-market accounting system produces more reliable

4Merton and Bodie [1992] illustrate that even when risky assets are subject to a guarantee (like deposit insurance), the moral hazard problem can be effectively controlled if efficient estimates of market value are available. The illustration is based on the system stockbrokers employ to handle customers' margin accounts. When an investor opens a margin account with a broker and borrows money to buy stocks or bonds, the broker effectively becomes a loan guarantor. However, even though margin accounts are established without extensive credit checks and even though such accounts can include highly volatile assets, the guarantee exposes the brokerage house to relatively little risk. As a result, the margin system functions with no special fee and low interest rates (typically substantially less than the prime rate). Brokers can provide an effective and low-cost guarantee because they set and monitor capital margins which are calculated in terms of the market value of the investor's securities. This same type of monitoring and seizure system is used by futures and options exchanges worldwide to protect the exchanges against losses from contract defaults by customers.

4 V. L. BERNARD, R. C. MERTON, AND K. G. PALEPU

estimates of value (as measured by stock prices) than the historical-cost book values produced in the United States. Evidence discussed in section 8 suggests that a combination of mark-to-market accounting and rigid regulatory intervention policies has led to low costs of resolving Danish bank failures.

Some implications of the Danish experience are summarized in section 9. While the Danish experience provides useful evidence on several issues regarding the desirability of implementing mark-to-market accounting in the U.S., two qualifications remain. First, in evaluating the relevance of the Danish evidence for the United States, one must take into account the vast differences between the two countries, including the number of banking institutions, political issues, the nature of investments, and the auditing and regulatory environments. Second, Denmark has both mark-to-market accounting and a rigid regulatory intervention system; the implementation of mark-to-market accounting in the United States may not be as effective as in Denmark, absent a change in regulatory intervention procedures. Moreover, given the U.S. history of regulatory forbearance for both thrifts and banks, there is cause to question whether an aggressive intervention policy would be tolerated. Subject to these caveats, the evidence reported in this study supports the use of mark-to-market accounting for financial institutions. The study also illustrates an approach for evaluating the effectiveness of mark-to- market accounting, should such a system be adopted in the U.S.

2. Implementing Mark-to-Market Accounting

Bank capital-adequacy regulations in the United States have tradition- ally relied on historical-cost accounting measures. Some adjustments recognize changes in the market values of assets or liabilities, but they fall short of eliminating the gap between book values and market values. The remaining gap stems primarily from four causes: (1) failure to recognize changes in the values of long-term investments and loans resulting from changes in interest rates; (2) delays in recognizing value decreases from increased credit risk; (3) failure to recognize changes in the values of liabilities; and (4) failure to recognize changes in the value of intangible assets, such as the so-called core-deposit premium.5 Com- prehensive mark-to-market accounting seeks to eliminate these gaps, but must address several challenges, as discussed below.

5 The core deposit premium derives from the banks' ability to raise funds from "core"

depositors who are less interest-sensitive than those in, say, the market for brokered de-

posits. The willingness of core depositors to forego fully competitive interest rates should

be based on the value of associated services rendered by the bank (such as free checking

services, convenience in making withdrawals, or advantages in borrowing). Thus, if the

core-deposit premium for a given bank constitutes an intangible asset, it must reflect the

ability of the bank to provide such services at low cost.


Estimation Errors. Market prices are not readily available for traditional bank assets and liabilities, including "middle-market" business loans, commercial real-estate loans, and some sovereign debt. Estimates of exit values for these assets are thus subject to significant errors. If the errors overstate values, the insurer will not intervene as quickly as it should, and the proceeds realized from seizure will be less than expected. If the errors understate the values, solvent banks will be seized and liquidated. This suggests that the valuation procedures should be symmetric and, hence, unbiased (see Merton and Bodie [1993]).

Because of the natural tension between banks and insurers over asset valuation, an effective mark-to-market system should constrain the opportunities for manipulation by using procedures that are known, agreed upon by both parties in advance, and difficult to manipulate. That is, an efficient mark-to-market system is one that, specified ex ante, gives the best estimate of the price at which an asset could be sold, using verifiable information.

Private Information. Even when market prices exist, they may not reflect the bank's private information. Such private information could also be used to improve the accuracy of estimated market prices, provided the information can be (confidentially) verified by an independent auditor. However, bank managers' incentives typically favor upward-biased estimates of asset values and downward-biased estimates of liabilities. It is, therefore, sometimes optimal to neglect banks' private information if doing otherwise creates opportunities for too much manipulation.

Illiquidity. Many traditional bank assets are illiquid, as evidence by large bid-ask price spreads, raising the question of what the appropriate price is for marking such assets to market. As long as assets are marked to market at the bid price (i.e., orderly liquidation price), the illiquidity of an asset serving as collateral is not a problem for the insurer. However, illiquid assets make a bank vulnerable to seizure when the bid price falls. If this risk is sufficiently large and the chances of a violation are not neg- ligible, it is inefficient for such assets to be treated as collateral in the deposit insurance system; they would be held more efficiently elsewhere.

Comprehensiveness. One important practical question is whether mark- to-market accounting should include liabilities and intangible assets. If assets are marked to market, but liabilities are not, net worth estimates will be distorted in a way that reduces incentives to hedge assets with liabilities, even though such hedging would reduce the bank's economic exposure.

In principle, intangible assets like goodwill and core-deposit premia could be included in regulatory net worth if these assets can be pre- served in liquidation or sale, and if their value can be reasonably estimated. However, if such estimates are too vulnerable to manipulation and error, it may be more efficient to ignore them; effectively, this would preclude the use of such intangibles as collateral to insured deposits.


Reliability and Volatility. Some argue that a market-value system might not produce more information than the current U.S. system that combines historical costs with footnote disclosures about interest rate and credit risk (Beaver, Datar, and Wolfson [1992]). That is, managers may be able to manipulate reported market values so that they are no more or even less informative than a combination of other more readily auditable disclosures. Of course, mark-to-market accounting could be required while preserving the existing set of readily auditable disclosures (such as data on nonperforming loans) that would permit outsiders to assess the reasonableness of the market-value estimates. Such a system would at least weakly dominate the current one in terms of the amount of information disclosed, though it would impose additional accounting costs on the banks.

Another complaint is that mark-to-market accounting produces volatile earnings and capital values (e.g., American Bankers' Association [1990]). Although proponents of mark-to-market accounting would counter that real economic volatility should be recognized, excessive volatility arising from measurement error in market-value estimates could lead to more frequent capital requirement violations, and hence premature interventions.6 Seidman [1991] claims that the mere act of intervention can destroy value up to 10-15% of assets. Seidman asserts that the loss arises from an erosion of the bank's intangible franchise value, and because (given their information disadvantage) purchasers require a discount even on good loans.7

As this discussion shows, the debate about the actual costs and benefits of implementing mark-to-market accounting for regulatory purposes is difficult to settle without empirical evidence. For example, the issue of measurement error raises questions about the extent to which a mark-to-market system is subject to manipulation. Similarly, the issue of volatility raises questions about, among other things, the effect of mark- to-market accounting on the frequency of regulatory capital violations and the benefits of tying capital requirements directly to market-value- based equity ratios.

To obtain evidence on the effects of direct reliance on market-value- based capital requirements, we turn to the experience of Denmark, which has long tied bank and savings bank regulatory capital requirements to a market-value accounting system. The same accounting system is used in Denmark for regulatory reporting and financial reporting to shareholders, allowing outsiders to monitor both bank managers and

6 Alternatively, to avoid violations, banks will be forced to hold higher levels of capital. Verification of this claim is complicated. An alternative possibility is that the losses

identified by Seidman are not a real destruction of value caused by intervention, but simply a recognition of economic losses not yet recorded within the historical-cost-based account-

ing system used in the United States.


regulators.8 Turning now to the empirical study, we analyze the Danish system from the bank regulators' point of view.

3. The Structure of the Banking Sector in Denmark

At the end of 1989, there were 71 banks (stock companies) and 131 savings banks (mutuals) in Denmark, with DKr 780 billion and DKr 280 billion in aggregate total assets (approximately $115 billion and $41 billion), respectively. Banks and savings banks offer a full range of banking services and are similar in terms of their activities.

Asset Structure. Table 1 describes the aggregate balance sheet structure and earnings components for the Danish banks and savings banks in 1989, and compares these structures to those of U.S. banks and thrifts. (The balance sheet structure in Denmark has changed little over the past 15 years.) The one readily apparent difference between the Danish and U.S. institutions is that the former are permitted to hold equity securities; those holdings amount to 1-4% of total assets (about 10-70% of owners' equity).

The balance sheets in table 1 indicate that about 15-20% of Danish bank assets are placed in cash and deposits; Danish banks are required to hold such liquid reserves in an amount not less than 15% of short- term deposits (those due within 30 days). Cash assets held by U.S. banks and thrifts are a smaller fraction of total assets. The bond investment portfolios of the Danish and U.S. banks are both slightly less than 20% of total assets and include a combination of domestic and foreign government bonds and mortgage-backed securities.

Loan portfolios (relative to total assets) are slightly smaller in Den- mark than in the United States (53% and 57% for Danish banks and savings banks, versus 62% and 61% for U.S. banks and thrifts, respectively). The contents of the portfolios are difficult to compare, since disclosures about their components are not uniform. However, as discussed below, there are few long-term mortgages in the Danish loan portfolios, so these appear more like those of U.S. banks than U.S. thrifts. The Danish loan portfolios contain mostly variable interest rate loans, rather than the mixture of fixed and variable rate loans found in the United States. Thus, bond portfolios are the major source of interest rate risk for Danish banks and savings banks.

In the United States, much of the debate on mark-to-market accounting has centered on the fixed-rate mortgage loans held by thrifts. In Denmark, such loans are originated only by a few (four as of 1989)

8 Whether the same accounting system is best suited for regulatory and financial reporting, however, is a complex question. While bank regulators are primarily interested in measuring market values in liquidation, shareholders are interested in the bank as a going- concern. Therefore, for financial reporting, market values based on both bid and ask prices are potentially relevant.


TABLE 1 Comparison of Financial Structure of Danish and US. Financial Institutions

Danish Danish Savings U.S. U.S. Banksa Banksa Banksb Thriftsc

1989 1989 1989 1988

Balance Sheet (all amounts scaled by total assets) Cash and Bank Deposits .19 .14 .08 .04 Investment in Debt Securities .18 .19 .17 .26d Investment in Stock .04 .03 .00 .00 Loans .53 .57 .62 .61 Premises .01 .02 .01 .01 Other Assets .05 .05 .13 .08

Total Assets 1.00 1.00 1.00 1.00

Deposits .45 .51 .70 .72 Debt to Banks .29 .25 NA NA Guarantees Issued .12 .08 Other Liabilities .05 .06 .24 NA Total Liabilities .92 .90 .94 .96 Subordinated Debt .02 .03 NA NA Owners' Equity .06 .07 .06 .04

Total Liabilities & Equity 1.00 1.00 1.00 1.00

Income Statement (all amounts scaled by total assets) Interest Income .081 .086 .094 .088 Interest Expense -.058 -.057 -.061 -.068 Spread .023 .029 .033 .020 Other Income .007 .007 .016 Other Expense -.027 -.034 -.041 -.027e Extraordinary Gains/Losses .001 .000 .000 .000

.004 .002 .007 -.008 Price Adjustment -.000 -.002 Pretax ROA .004 -.001 .007 -.008

Tax Expense -.001 .000 -.003 -.002 ROA .003 -.000 .004 -.009

aSource: Danish Financial Supervisory Authority Yearbooks. bData for commercial banks, as reported in Ritter and Silber [1990] based on FDIC and Federal

Reserve data; NA = not available. cData for FLSIC-insured savings institutions, as reported in the Savings Institution Sourcebook (U.S.

League of Savings Institutions [1989]); NA = not available. dIncludes mortgage-backed securities and other debt securities, and insured mortgages. e0ther income and other expense are netted together.

mortgage credit associations. The interest rate risk associated with the

loans is almost immediately passed through to Danish banks, savings

banks, and other buyers of mortgage-backed bonds issued by the credit

associations. Thus, the problem of accounting for changes in the value

of mortgages lies not in the Danish bank loan portfolios but in their in-

vestment portfolios. Supervision and Capital Requirements. Danish banks and savings banks

are regulated and monitored by the Danish Financial Supervisory Au-

thority ("Supervisory Authority"), an agency of the Ministry of Industry.


Through 1990, the Supervisory Authority required that bank capital (including stock, retained earnings, and subordinated debt) be at least 8% of total liabilities (equivalent to 7.4% of total assets).9 Beginning in 1991, Danish banks were required to comply with the risk-based capital requirements to be adopted by the European Economic Community under the auspices of the Bank for International Settlements (BIS). For most banks, the BIS standards allow lower levels of capital than previously required in Denmark.

When a bank's or savings bank's capital falls below the required level at the end of any quarter, the Supervisory Authority allows six months for the institution to raise new equity or otherwise satisfy the capital requirement.10 New bank equity in Denmark is typically raised through a rights offering to current shareholders, usually at a discount. If at the end of the six months the bank is still not in compliance, the Supervisory Authority immediately places the bank under new control, generally by arranging an acquisition by a healthy bank. In this process, the Super- visory Authority serves as a merger broker, identifying a willing acquirer in advance, so that the change of control can occur quickly and with little publicity. In two cases during 1987 (6. juli Banken and C & G Ban- ken), a willing acquirer could not be found and the banks were closed.

Deposit Insurance. Prior to 1988, Denmark maintained no official deposit-insurance system. Since that time, in compliance with European Community Directives, a deposit-insurance fund has been established, and banks contribute an annual insurance premium of two-tenths of 1% of their deposits. The insurance guarantee applies to deposits up to DKr 250,000 (currently about $37,000). When the C&G Banken failed soon after deposit insurance was established and was found to have negative net worth, the Danish government covered the resulting deficiency to small depositors. After that case (and through 1991), the Supervisory Authority intervened in 23 institutions because of capital deficiencies, but no government financial assistance was necessary to cover obliga- tions to depositors.

4. The Danish Accounting System for Banks and Savings Banks

4.1 SUMMARY OF ACCOUNTING RULES

Accounting principles for banks, savings banks, and mortgage credit associations are established by the Danish Supervisory Authority. With the exceptions noted below, accounting is based on a mark-to-market approach for tax, financial reporting, and regulatory purposes.

9 Note that since the Danish capital ratios are expressed as fractions of liabilities, they are not directly comparable to those in most other nations, where capital is expressed as a fraction of assets. The Danish capital ratio (say, a) can be converted into a ratio based on assets, via the formula (a/(1+a)).

lo This regulation was in place through 1990, and thus throughout the period of our empirical tests. Since 1990, the six-month grace period has been eliminated.


Investment securities, including stocks and bonds, are accounted for at market value so long as the price is publicly quoted. Gains and losses affect both earnings and owners' equity. Unquoted securities (typically less than 10% of the investment portfolio) are carried at lower of cost or market.

Loan portfolios carry primarily variable rates, and thus the key deviation between the nominal loan portfolio balance and current market value arises from changes in credit risk. The Danish system requires a provision for loan losses that is sufficient to cover "both known and foreseeable losses." The regulations provide no explanation of this rule; those we interviewed-including representatives from auditing, banking, and the Supervisory Authority-interpreted the rule to indicate that the loan balance, net of provisions, should approximate current market value. In contrast, under U.S. GAAP (SFAS No. 5 on accounting for contingencies), loan losses need not be recognized until they are "probable." Also, until implementation of SFAS No. 114 (on loan impair- ments), and depending on how extensively banks applied the spirit of SFAS No. 15 (on troubled loan restructuring), U.S. GAAP did not necessarily require any loss recognition so long as undiscounted expected future cash flows exceed the loan principal.

In Denmark, there is essentially no secondary market for the loans carried by banks and savings banks, so dealer quotes for similar loans are not available. Furthermore, there is no required set of systematic procedures to estimate the provision for loan losses. Those we interviewed uniformly labeled the estimation process as subjective. Thus, the Danish system of accounting for loans is potentially more vulnerable to manipulation than objective approaches like those proposed by Berger, Kuester, and O'Brien [1990].

f

For the small number of loans with fixed interest rates, the Danish rules require the recording of losses in value due to interest rate swings, but permit the recording of gains only to the extent that previous unrealized losses are offset.

Fixed assets typically represent only 1-2% of the total assets of a Danish bank. Land and buildings can be written up or down, based on government assessments, so long as the appreciation or depreciation is deemed to be of a permanent nature. Machinery and equipment is carried at depreciated cost.

Of-balance sheet assets and liabilities such as interest rate swaps, currency swaps, futures, and forward contracts are also marked to market, with gains and losses included as a component of earnings. Some of

1 Berger, Kuester, and O'Brien recommend approximating loan values by adjusting directly for changes in the general level of interest rates, and then adjusting for credit risk based on a statistical model. The statistical model incorporates bank-specific information about loan charge-offs, and past-due, nonaccruing, and renegotiated loans. Such an approach is feasible and objective, but potentially excludes bank-specific information that could be considered in a more subjective approach.


these off-balance sheet items are traded in active markets, and others (e.g., forward contracts) can be priced by reference to a combination of traded securities. In other cases, market values are based on dealers' quotes or must be estimated using discounted cash-flow techniques, option-pricing models, or other approaches.

Liability accounts are not subject to mark-to-market accounting. How- ever, two factors minimize the importance of this deviation from a comprehensive mark-to-market system. First, most liabilities (other than subordinated debt, which is considered capital) are short-term; hence, they are relatively unaffected by interest rate swings. Second, any unrealized gain or loss on swaps intended to hedge fixed-rate liabilities need not be recognized in earnings. Thus, for directly hedged positions, the accounting yields the same impact on earnings and owners' equity (no net gain or loss) as mark-to-market accounting for both assets and liabilities.

There is no attempt in the Danish system to account for intangible assets, such as a core-deposit premium, unless such intangibles are recorded as purchased goodwill.

To summarize, the accounting system used for Danish banks and savings banks marks to market the vast majority of banks' assets and off- balance sheet items. However, the accounting does differ from a comprehensive mark-to-market system, most importantly in that it ignores the value of internally developed intangible assets. Other deviations, including the failure to mark liabilities to market and the failure to record appreciation on fixed-rate loans due to interest rate declines, are less important given the structure of Danish banks, even though such deviations could be quite important in other contexts.

4.2 AUDITING OF DANISH BANKS AND SAVINGS BANKS

The above-described subjectivity in accounting for loan loss provisions suggests the potential for substantial management discretion. However, Danish banks and savings banks must be audited by at least two independent firms (who may share the scope of the audit). In addition, the internal audit staffs of banks and savings banks report directly to the board of directors, potentially offering another independent assessment of the accounts. Finally, the Supervisory Authority periodically conducts its own examinations. Thus, in principle, the financial statements are subject to audit by four independent parties. In addition, audit firms can be dismissed and replaced by the Supervisory Authority. Auditors are held directly responsible, along with management and the board of directors, for reporting difficulties (such as capital deficiencies) to the Authority.

5. Capital Ratios and Volatility Due to Mark-to-Market Adjustments

Given the strict enforcement of capital regulations in Denmark, if mark-to-market accounting increases earnings volatility, and that volatility can be offset only by costly changes in asset bases or frequent


equity offerings, then banks may choose target capital levels well above the required minimum. In this section, we examine Danish bank capital ratios and the degree of volatility in those ratios due to mark-to-market adjustments.

In these and subsequent empirical analyses, we use financial statement data obtained from annual publications of the Danish Financial Supervisory Authority. The full sample includes 1,035 observations for all Danish banks for 1976-89; the number of banks per year varies from 69 to 78. Analysis of the full sample provides information about the average behavior across all banks. However, because the six largest banks dominate the industry and are of interest in their own right, we also analyze the 84 observations available in that subsample.12

Table 2, panel A describes the distribution of capital ratios (equity and subordinated debt, scaled by total liabilities excluding subordinated debt) for the full sample and the large-bank subsample for 1976- 89. Within the full sample, capital ratios frequently exceed the required minimum 8%; nearly half of the observations fall above 11%, and more than a third fall above 12%. The mean of this skewed distribution is 17%. The six large banks maintain capital ratios closer to the minimum requirement; for these banks, the median (mean) ratio is 8.9 (9.1)% and nearly all observations fall below 11%.

Table 2, panel B indicates how two key mark-to-market accounting adjustments affect reported bank profitability. The first is the loan loss provision, which (at least in principle) represents a market-based adjustment for credit risk. The second is the so-called price adjustment, which reflects realized and unrealized gains and losses on investments, interest rate and currency swaps, and fixed-rate loans and mortgage deeds.13 Since the evidence in panel B requires a time series of reason- able length, we include only the fraction 57 banks with a complete series of data from 1976 through 1989.

Table 2, panel B indicates that, before considering the impact of the two primary mark-to-market adjustments and some other minor items, annual pretax earnings increase capital for the full sample by an average of 17.3%. To help assess how this pretax earnings number contributes to volatility in the capital ratio, table 2 reports that (on average across banks) the time-series standard deviation in pretax earnings is 5.1%.

Mark-to-market adjustments increase the earnings-induced volatility in capital. Price adjustments, with a mean effect of 6.4%, have an average standard deviation of 19.6% -nearly four times the standard deviation

12 The actual number of usable observations is sometimes less than indicated here, typically because the test requires lagging the data, but in one case because an outlier is excluded in accordance with a procedure described later.

13 Gains and losses on some financial instruments, including forward rate agreements and interest rate and currency options, are treated as adjustments to interest income/ expense or currency gains/losses, and thus we have no detailed data on these items.


TABLE 2 Capital RatiosforDanish Banks, 1976-89: Level, Volatility,

and Impact of Mark-to-Market Adjustments

Panel A: Level of Capital Ratiosa Percentage of Observations

Six Large Banks Full Sample

Capital Ratio (N= 84) (N= 1,035)

Greater than 15% 0.0 14.9

12-15% 0.0 20.6

11-12% 1.2 12.3

10-11% 21.4 14.0

9-10% 25.0 17.5

8-9% 44.0 14.0

Less than 8% 8.3 6.8 100.0 100.0

Mean Capital Ratio 9.1 17.0

Median Capital Ratio 8.9 10.8

Panel B: Impact of Mark-to-Market Adjustments on Volatility of Capital

(amounts expressed as percentages of capital) Sample of 57 Banks

Six Large Banks with Full Time Series

Mean of Mean of

Mean of Firms' Mean of Firms'

Firms' Standard Firms' Standard

Impact on Capital of Means Deviations Means Deviations

Earnings before Loan Loss

Provisions, Price Adjustments, Depreciation, Extraordinary Items, and Taxes 13.6% 5.7% 17.3% 5.1%

Price Adjustments (Driven Pri-

marily by Gains/Losses in

Bond Market) 9.2 17.9 6.4 19.6

Loan Loss Provisions -6.3 5.6 -7.5 6.5

Earnings before Taxesb 13.3 13.4 14.8 17.4

Earnings after Taxes 9.6 7.9 9.2 11.8

Incremental Effect of Capital

Transactions (Dividends, Stock Issues, etc.) 2.5 11.2 2.1 1.6

Annual Change in Capital Ratio 12.1% 19.1% 11.3% 13.4%

aCapital ratio is defined by the Danish Financial Supervisory Authority as shareholders' equity plus subordinated debt, scaled by total unsubordinated liabilities.

bNote that only a subset of the components of earnings before taxes are listed above this row. Thus, the means above this row are not intended to sum to the mean of earnings before taxes.

of the pretax earnings before mark-to-market adjustments. Loan loss provisions have a mean effect of -7.5% and an average standard deviation of 6.5%. One would expect some offsetting of these effects; for example, rising interest income on variable rate loans and gains on certain hedges against rising interest rates (included in earnings before price


adjustments) would tend to coincide with losses on fixed-rate bonds (included among price adjustments). Thus, it is not surprising that the standard deviations fail to aggregate as if the components were independent. The average standard deviation in the sum of the components (i.e., total pretax earnings) is 17.4%, less than that for the price adjustments component. This indicates that interest rate exposure in the bond markets- the primary driver of price adjustments-is important, but other components of earnings partially hedge that exposure.

After tax, earnings from all sources increase capital by 9.2% on average, with an average time-series standard deviation of 11.8%. To appreciate the significance of earnings volatility, it is necessary to consider its impact on the capital ratio (capital scaled by liabilities). Based on the empirical distribution for the full sample, the probability of a loss large enough to reduce the capital ratio by one percentage point is approximately 20%, and a bank with a ratio close to the median faces approximately a 2% probability of violating the 8% threshold, before considering any other effects.

Table 2, panel B also shows that the earnings-induced volatility in capital ratios is about two-thirds as large for the six large banks as for the full sample. Again, much of this volatility is due to price adjustments. The large banks' lower earnings volatility may partially explain their smaller "cushion" above the minimum capital requirements.

Overall, table 2 indicates that mark-to-market adjustments-particularly the price adjustments-contribute to earnings volatility for Danish banks. Whether this effect would be observed in other countries depends on both the extent of hedging and the completeness of the mark-to-market accounting. In the extreme case of comprehensive mark-to-market accounting for a bank that is perfectly hedged against interest-rate exposure, market value adjustments could offset not only each other, but also some earnings volatility before such adjustments. One implication from table 2 is that Danish banks do not use investments and off-balance-sheet positions to offset earnings volatility that arises from fluctuating rates on variable rate loans and deposits.

The low (less than 2%) probability of an annual loss large enough to cause violation of capital requirements for the average Danish bank may simply reflect the sizable equity cushions maintained by these banks. The costs of maintaining these cushions arise generally from mecha- nisms for dealing with conflicts of interest between guarantors and the guaranteed; it is not clear such costs represent an inefficiency, relative to other feasible approaches to managing a banking system.

6. Evidence of Manipulation of Market-Value Numbers by Danish Banks

The vulnerability of a mark-to-market accounting system to management manipulation reduces its value to a deposit-guarantee system. In


this section, we examine the extent to which loan loss provisions and price adjustments appear to have been "managed" in Denmark. Our pri- ors are that the loan loss provisions are more vulnerable to manipulation, due to the subjectivity of the estimation process. Much of the gain or loss reflected in the price adjustment is based on publicly observable market prices, and we expect it to be less vulnerable to manipulation.

While we would prefer to separate the discretionary and nondiscretionary components of mark-to-market adjustments (see Healy [1985], Kaplan [1985], and McNichols and Wilson [1988] for a discussion), there is little publicly available information that would facilitate such a segregation. For example, Danish banks do not provide data on nonperforming loans, or even the balance of loan loss allowances (loans are reported net of this amount). As a result, we use purely statistical procedures to isolate discretionary adjustments to earnings. The implication is a loss of power to identify manipulation, the magnitude of which is difficult to assess, and in the case of one set of tests to be discussed later, a bias in the same direction as manipulation.

6.1 A GENERAL TEST FOR "SMOOTHING" OF MARK-TO-MARKET ADJUSTMENTS

Our first set of tests examines the extent to which price adjustments and loan loss provisions are recognized only gradually. If asset prices follow a random walk, then successive price adjustments will be uncor- related; but if managers smooth these price adjustments, the reported adjustments will be related over time. A similar logic applies for provisions. If provisions are sufficient for all known and foreseeable loan losses, as required by Danish law, then they should not be correlated over time. However, if managers adjust provisions only gradually when credit risks change, then provisions will be serially correlated.

We also test whether loan loss provisions and/or price adjustments are managed so as to offset each other and thus smooth reported income.14 There are several reasons income smoothing might be desired. For tax purposes, Danish managers have an incentive to minimize current earnings, subject to maintaining the required level of capital. Assuming a smooth pattern of dividends and a steady level of required capital, that objective can be met by smoothing income. Managers may also be concerned about adverse investor reaction to earnings volatility.

The tests are conducted in two ways. First, we aggregate the banks into a single group, and examine the resulting time series of 14 observations (1976-89) to test for industry-wide manipulation of mark-to-market ad-

justments. The second approach is based on pooled regressions and focuses on firm-specific manipulation. In the pooled regressions, a fixed- effect error-term formulation is adopted, under which the error term is

14 Scholes, Wilson, and Wolfson [1990] show that, for a sample of U.S. banks, loan loss provisions seem to be managed to offset gains/losses on security sales. Beatty, Chamber- lain, and Magliolo [1994] report other forms of income management by banks.


assumed to contain a time-invariant, firm-specific effect (e.g., ali for loan loss provisions), a sample-wide, yearly effect (e.g., a2t for loan loss provisions), and a random disturbance (e.g., 8it). This is equivalent to expressing all data as deviations from the associated firm and year effects (e.g., ali + a2t) (see Judge et al. [1980, p. 330]). As a result, these tests can detect whether banks are managing "abnormal" provisions or price adjustments-those that deviate from current industry experience and the long-run average experience for the given bank. If these benchmarks are largely beyond management control, then the pooled regressions should isolate the discretionary component of the mark-to- market adjustments within the "abnormal" deviations.

The pooled regressions based on firm-specific data take on the following forms:

LLPitlLoansit = aoLLPit- IlLoansit- 1 + cli + a2t + sit (1)

PAdjit/Assetsit = PoPAdjit - I /Assetsit - 1 + f0 i + 02t + (bit (2)

LLPitlLoansit= yOPAdjit/Assetsit + Yli + 72t + 0it (3)

where:

N T N T N T

Ecli= I a2t =; E li I E 2t = ?; E lij= I 2t =; i=1 t=1 i=1 t=1 i=1 t=1

a(li, 1li, and yli = firm-specific components of error terms; a2t, P2t, and 72t = year-specific components of error terms;

LLPitlLoansit = loan loss provisions for firm i in year t, scaled by total loans;

PAdjitlAssetsit = price adjustments for firm i in year t, scaled by total assets.'5

The time-series regressions based on industry data contain the same variables as the pooled regressions, but with no firm or year dummies in the error structure.

When equations (1) through (3) are estimated with pooled time-series cross-sectional data, there is a potential for bias in standard error estimates resulting from both cross-sectional heteroscedasticity and cross- sectional dependence that remains after controlling for industry-wide shifts in the data (see Bernard [1987]). For that reason, we report an alternative set of estimates in which we allow the slope coefficients to vary by year, and then report the mean of the series of annual co-

15 Ideally, we would scale price adjustments by the balances subject to the adjustments. Thus, instead of using total assets, we would exclude cash, equipment, and variable rate

loans, while including some off-balance-sheet items. The data necessary to achieve this ideal are not available from our source, however, and amounts of variable rate loans and some of the desired off-balance-sheet data are not available even from the original Dan- ish financial statements. Thus, the analysis assumes that total assets are a good indicator of the ideal measure. If the assumption is incorrect, we forfeit efficiency but have no reason to suspect bias.


efficients.16 The standard deviation of that time series provides the basis for the associated t-test.17 'While this alternative test is free from bias in standard errors due to cross-sectional heteroscedasticity or dependence, it may forfeit some statistical efficiency by placing equal weight on the coefficient estimates from each year. In the pooled regressions, the influence of each year's data depends on the dispersion in the regressors and the sample size.

Table 3 reports the results of the tests.'8 In the time-series regressions, with only 14 annual observations, there is limited power to detect serial correlation. Nevertheless, so far as loan loss provisions are concerned, we still find reliably positive serial correlation in the full sample. For price adjustments, we find no significant serial correlation, and thus no indication of manipulation.

The time-series estimates on the right-hand side of table 3 indicate that, consistent with income smoothing, approximately one-third of the variation in price adjustments is offset by variation in loan loss provisions. Although we can imagine economic conditions that would induce such an effect, we would not necessarily expect this effect in the absence of manipulation. That is, we would not necessarily expect positive price adjustments (driven largely by falling interest rates and resulting gains in the bond market) to occur simultaneously with higher loan losses (driven largely by rising credit risks).

The results of the pooled cross-sectional regressions generally cor- roborate those from the time-series regressions. We find no significant serial correlation in price adjustments for either sample, and significant correlation for the loan loss provisions for the full sample only. The latter result suggests that when a bank's expected loan losses deviate from their average level relative to the current industry-wide experience and the banks' long-run average experience, the bank recognizes such losses only gradually. The regression estimate of .30 suggests that a recorded loss of DKr 1 tends to be followed by another recorded loss of DKr .30 in the subsequent year, of DKr .09 two years hence, and so on. The implication is that about 70% of the expected loss is recognized immediately.

For comparison purposes, table 3 also includes pooled-regression results (based on equation (1)) for the 1977-88 loan loss provisions of 106 U.S. banks examined in Wahlen [1994]. The serial correlation in

16 We do not attempt the alternative test for the subsample of six large banks. 17 The time-series-based t-test relies on the assumption that the coefficients are serially

independent-an assumption also underlying the pooled regressions. Supplemental analysis supports the reasonableness of this assumption.

18 Throughout this and the subsequent regression analyses, we exclude the effects of "influential observations": those with a Cooke's D-statistic of greater than one. (Cooke's D is a measure of the influence an observation has on the vector of estimated regression coefficients; see Weisberg [1985].) Influential observations are an issue only in estimating equation (1) with the full sample, and even there the sign and significance of the primary coefficient are unaffected (see footnote to table for details).


TABLE 3 Tests for Earnings Management: Gradual Recognition and Smoothing of Changes in Value

(Based on Regression Equations (1), (2), and (3) in Text)

Tests of Gradual Recognition of Changes Tests of Smoothing in Value (Coefficient from Regression (Coefficient from Regression of Current Component of Earnings of Loan Losses on Price

against Lagged Amount) a Adjustments) a

Contemporary Relation Serial Relation in Serial Relation in between Loan Losses

Loan Loss Provisions Price Adjustments (LLPVt/Loans.t) and Price

(LLPit/Loan.~t) (PAdjit/Asset.~t) Adjustments (PAdjit/Assetsqt)

Coefficient t-Statistic Coefficient t-Statistic Coefficient t-Statistic

Time-Series Regressions for Banks as a Group (14 Observations, before Lagging Data) Six Large Banks .45 1.75 -.12 -.41 .34 4.34* Full Sample .48 1.91* -.21 -.73 .29 2.91 *

Pooled Time-Series Cross-Sectional Regressions (Results Driven by Firm-Specific Deviations about Mean for Firm and Year)b

Six Large Banks (N= 84, before Lagging Data) Estimates from Pooled

Regression -.06 -.47 -.02 -.17 .86 8.40* Full Sample (N= 1,035, before Lagging Data)

Estimates from Pooled Regression .30c 5.88* -.05 -1.60 .11 2.21*

Mean of Coefficients Allowed to VarybyYear .35 3.91* .26 1.58 .05 .41

U.S. Banks (N= 1,241) Estimates from Pooled

Regression .32 10.20* NA NA NA NA

aLoan loss provisions are scaled by total loans; positive provisions are expenses. Price adjustments are scaled by total assets; positive adjustments are gains.

bTo control for industry-wide movements and variation across firms in the mean levels of the variables, the pooled regressions are estimated with a fixed effect error formulation. Specifically, the error term is assumed to consist of one component that varies across time, a second component that varies across firms, and a random disturbance term.

cThis result is based on sample after deletion of the only "influential observation" (that with a Cook's D statistic in excess of one). When all observations are used, the coefficient is .12, with a t-statistic of 2.95. No other tests involved observations with a Cook's D in excess of one.

*Statistically significant (based on one-tailed test) at .05 level.

U.S. banks' loan loss provisions, after controlling for year- and firm- effects, is .32, about the same as that documented for the Danish banks. One might have expected more serial correlation in Denmark, since the tax- and capital-regulation-related motives for smoothing earnings in Denmark do not apply to loan loss provisions in the U.S.19 The result demonstrates that Denmark's explicit legal requirement not to delay foreseeable loan losses does not overcome the tendency for delay that was long codified in the U.S. accounting rules.

19 In the U.S., loan loss provisions for tax purposes are not based on those taken from public financial reports and analyzed here; moreover, while recording of loan loss provisions decreases regulatory capital in Denmark, it increases capital in the United States (see Moyer [1990]).


The final result in table 3 is the pooled regression that examines the contemporaneous relation between loan loss provisions and price adjustments. These regressions indicate a significant degree of offsetting of the two mark-to-market adjustments in the firm-specific data. For the sample of large banks, the estimates suggest that 86% of the variation in price adjustments is offset by variation in loan loss provisions. For the full sample, the magnitude of the effect is only 5% or 11%, depending on the estimation approach, and is not statistically significant when we use the t-test free from bias due to cross-sectional heteroscedasticity and dependence.

The contemporary relation between loan loss provisions and price adjustments found for the large banks could reflect manipulation of either or both numbers. However, given the subjective nature of the loan loss estimates and the fact that much of the price adjustment is driven by gains and losses on publicly traded bonds, a likely explanation is that loan loss estimates are managed by the large banks so as to "smooth" the impact on income of the price adjustments.20

6.2 MANIPULATION OF MARK-TO-MARKET ADJUSTMENTS TO MEET CAPITAL

REQUIREMENTS

In this section we report evidence on whether loan loss provisions and price adjustments are manipulated to avoid violations of capital requirements. The tests are intended to isolate the discretionary components of provisions and price adjustments, and then to compare them across three groups of low, medium, and high capital ratios (calculated as capital as a percentage of total liabilities) prior to estimated discretionary accruals (calculated as explained below).21 The low category includes those banks with ratios less than 9% (the ones closest to the 8% minimum capital requirement); the medium category consists of banks with capital ratios between 9% and 11%; the high category consists of

20 The most direct approach to testing for earnings smoothing earnings would be to examine whether loan loss provisions and/or price adjustments offset the variation in

earnings before these adjustments. However, such tests are difficult to interpret, because there are sound economic reasons to expect some offsetting even in the absence of earn-

ings management (or that the offsetting effects due to earnings management could be masked). For example, since (during our test period) earnings before price adjustments include some gains/losses on positions used to hedge against the gains/losses reflected in the price adjustments themselves, one would expect a negative relation between those

components of earnings-consistent with smoothing-even if earnings were not manipulated. (Such a negative relation does exist.) Given that interest income is reduced as loans become nonperforming and loan losses are recognized, there are also reasons to

expect a negative relation between pre-loan-loss, pre-price-adjustment earnings, and loan loss provisions-which could mask the effects of smoothing. (Indeed, there is some mixed evidence of such a relation.)

21 A continuous variable is not used here, because we hesitate to rely on an assumed functional form relating that variable to discretionary accruals. Instead, we hypothesize only that such accruals vary, on average, across categories.


banks with capital ratios larger than 11%.22 Under the hypothesis of manipulation, we expect to see a lower provision and/or higher price adjustment for banks in the low category, relative to other banks.

The tests are conducted within the framework of the following dummy-variable regression models:

LLPitlLoansit = 1Diltw+ 62L. ed+ 63Dih+ l + + tit (4)

PAdjitlAssetsit = lD0low + 02Drned + 03.high + + I2t + fit (5)

(PAdjit - LLPit) /Assetsit =

plDilw + l

p2Dwed + 3D high + + V2t + coit (6)

where:

N T N T N T

EIli= EI2t= E- 1ii= E I 2t= IVi= I V2t = 0; i=1 t=1 i== t=I i=I t=I

l9i, Flit and v1i = firm-specific components of error terms; 12tg 92t, and v2t = year-specific components of error terms;

LLPitlLoansit = loan loss provisions for firm i in year t, scaled by total loans;

PAdjitlAssetsit = price adjustments for firm i in year t, scaled by total assets; and

Diltow Dzned, and D high = dummy variables indicating that, prior to estimated discretionary loan loss provisions and price adjustments, the capital ratio for firm i in year t is low (< 9%), medium (9 to 11%), or high (> 11%), respectively.

Regression models (4), (5), and (6) each include a fixed-effect error structure like that used in models (1), (2), and (3). For example, equation (4) assumes that the error term includes a firm-specific component (ili)g a sample-wide, year-specific component (2t), and a random component (fit). Under the assumption that the nondiscretionary por- tions of loan loss provisions include only year-specific and firm-specific effects, they are captured in the term ('iIi + r92t). Any remaining systematic variation across the capital ratio categories (i.e., that reflected by the coefficients (61, 62, and 63)) must be due to discretionary accruals.

The above discussion pertains to isolation of the discretionary component of the dependent variable. Segregation of discretionary from nondiscretionary accruals is also an issue for the right-hand-side variables that assign banks to low, medium, or high categories of capital ratios. Ideally, we would classify firms on the basis of their capital ratios without

22As discussed later in this section, we perform sensitivity analysis to test the robust- ness of the results with respect to this classification.


the effects of discretionary accruals.23 To that end, we adjust the reported capital ratios by removing the effect of the year's total loan loss provisions and price adjustments on a net-of-tax basis, and then substi- tuting the effect of an estimated net-of-tax nondiscretionary provision and price adjustment. The estimated nondiscretionary portion of each accrual is (when scaled by loans or assets) equal to the scaled sample mean for the year, plus a mean firm effect equal to the amount by which a bank's scaled mean over all years differs from the grand scaled mean.24 The marginal tax rate is estimated at .50, the statutory tax rate in Denmark throughout our test period. This process of adjusting the right-hand-side variables is consistent with the previously described approach to controlling for the nondiscretionary component of the dependent variables, except that it is done on a net-of-tax basis.

Error in our measures of discretionary accruals tends to increase the standard errors of our coefficients, thus reducing the power to detect manipulations. At the same time, because the estimated discretionary component isolated from the dependent variable is proportional to the estimated component removed from the capital ratios underlying the right-hand-side dummy variables, the measurement error also induces coefficient bias that works in favor of a finding of manipulation.25 Un- fortunately, as indicated earlier, data limitations preclude a cleaner approach.

Since cross-sectional dependence is a potential concern in the pooled regressions, we again supply (as in table 3) alternative estimates and t-statistics based on time-series standard errors for the full sample.

23 The desirability of modeling discretionary accruals as a function of right-hand-side variables not influenced by the discretion has long been recognized (see Healy [1985]), but some prior studies have relied on alternative procedures. Stinson [1992] models discretionary accruals for U.S. thrifts as a function of reported capital ratios, by assuming that those most likely to have manipulated earnings are the ones whose reported ratios barely achieve the required minimum. Moyer [1990] models discretionary accruals for U.S. banks as a function of reported capital ratios, relative to the required minimum.

24 For example, if loan losses are 1.5% of loans for the full sample in a given year, and bankA tends to have loan losses 0.5% higher than the sample-wide average, the nondiscretionary loan loss provision for bank A in that year would be estimated at 2.0% of loans. For purposes of assigning bank A to a high, medium, or low capital category, capital would be adjusted so as to reflect a provision of 2.0% of loans (net of an estimated 50% tax effect), instead of the actual provision. The same approach would also be applied to price adjustments.

25.To illustrate, assume a nondiscretionary positive price adjustment by one bank is misclassified as discretionary. This gain will remain in that portion of the dependent variable to be allocated to one of the three capital ratio categories, thus biasing upward at least one of the three associated coefficients. At the same time, since the gain is mistak- enly considered discretionary, its net-of-tax effect is removed from capital before assigning the firm to a capital ratio category; this would tend to place the bank in too low a category. The upshot is a tendency to bias upward the coefficient on lower capital ratio categories-thus producing a result consistent with weaker banks manipulating their price adjustments upward. A bias consistent with manipulation also arises when loan loss provisions are misclassified.


Tests for Manipulation of Loan Loss Provisions. Panel A of table 4 reports the results of tests for manipulation of loan loss provisions to avoid regulatory capital constraints. For the sample of six large banks, we test for a difference only between the low and medium capital-ratio categories, since there was but one observation in the high category. The mean ratio of loan loss provisions to loans is 1.07% for the low category, insignificantly higher than the .96% mean for the medium category. Thus, there is no indication of manipulation for this group of large banks.

For the full sample of banks, the provisions/loans ratio increases slightly across the low, medium, and high capital-ratio categories, from 1.51%, to 1.52%, to 1.53% based on the first estimation approach, and from 1.39%, to 1.51%, to 1.55% based on the alternative estimation approach. While this pattern is consistent with downward manipulation of loan loss provisions for banks closest to the regulatory capital con- straint, differences among categories are not statistically significant.

Although the regulatory capital requirement for our sample was 8%, we included banks with ratios up to 9% in the low category, increasing the number of observations in that cell from 82 to 221 in an effort to increase statistical power. Perhaps, however, only the banks below the 8% regulatory requirement have strong incentives to manipulate mark-to- market adjustments. To assess this possibility, we repeated the analysis with an 8% cutoff (results not reported) and found no reliable indications of manipulation.26 In fact, the low-category banks in the full sample actually recorded larger loan loss provisions than the medium category or the high category. For the subsample of six large banks, the loan loss provisions were also (insignificantly) larger for the low category.

These results based on Danish data can be compared to others for U.S. banks and thrifts. Evidence for U.S. banks in Moyer [1990] and Beatty, Chamberlain, and Magliolo [1994], as well as Stinson's [1992] evidence on U.S. thrifts, indicates that loan loss provisions are manipulated by institutions close to the regulatory capital requirement, in a direction consistent with increasing reported capital. While precise comparisons cannot be made (in part because of possible differences in the power of the tests), the evidence is consistent with the hypothesis that manipulating loan losses to avoid regulatory capital constraints is more preva- lent in the United States than in Denmark.

Tests for Manipulation of Price Adjustments. Evidence on the relation between capital ratios and price adjustments (panel B of table 4) indicates that gains on price adjustments are higher for the more poorly capitalized banks, consistent with manipulation. However, only the results from the full-sample pooled regression, where bias in standard

26 The time-series based t-tests are not feasible here, since there are some years with

no observations in the low category. Thus, the supplemental analysis is based only on the

pooled regressions.


TABLE 4 Tests of Earnings Management to Avoid Regulatory Intervention

Panel A: Variation in Mean Level of Provisions/Loans Ratio, across Levels of Capital Ratio before Estimated Discretionary Accruals a

Capital Ratio less than 9% Capital Ratio 9-11% Capital Ratio above 11%

t-Statistic for t-Statistic for Mean Mean Difference Mean Difference

Sample and Estimation Provisions/ Provisions/ from Low Provisions/ from Low Method Loans Ratio Loans Ratio Capital Group Loans Ratio Capital Group

Six Large Banks (N= 78): Pooled Regression 1.07 .96 -.48 NAb NAb

Full Sample (N= 936): Pooled Regression 1.51 1.52 .06 1.53 .12 Mean of Annual Coefficients, and

Time-Series-Based t-Test 1.39 1.51 .18 1.55 .22

Panel B: Variation in Mean Level of Price Adjustments/Assets Ratio, across Levels of Capital Ratio before Estimated Discretionary Accrualsa

Capital Ratio less than 9% Capital Ratio 9-11% Capital Ratio above 11%

t-Statistic for t-Statistic for Mean Price Mean Price Difference Mean Price Difference

Sample and Estimation Adjustment/ Adjustment/ from Low Adjustment/ from Low Method Assets Ratio Assets Ratio Capital Group Assets Ratio Capital Group

Six Large Banks (N= 78): Pooled Regression .89 .64 -1.28 NAb NAb

Full Sample (N= 936): Pooled Regression 1.18 .88 -3.09 .82 -3.11 Mean of Annual Coefficients,

and Time-Series-Based t-Test 1.15 .88 -.67 .84 -.94

Panel C: Variation in Mean Level of Mark-to-Market Accruals/Assets Ratio, across Levels of Capital Ratio before Estimated Discretionary Accruals axc

Capital Ratio less than 9% Capital'Ratio 9-11% Capital Ratio above 11%

t-Statistic t-Statistic for Mean Mean for Difference Mean Difference

Sample and Estimation Accruals/ Accruals/ from Low Accruals/ from Low Method Assets Ratio Assets Ratio Capital Group Assets Ratio Capital Group

Six Large Banks (N= 78): Pooled Regression .34 .12 -1.28 NAb NAb

Full Sample (N= 936): Pooled Regression .41 .09 -2.23 .00 -2.55 Mean of Annual Coefficients,

and Time-Series-Based t-Test .45 .11 -.63 .00 -.66

aMeans for each capital ratio group are estimated within a regression of the accrual (either scaled loan loss provision in panel A, or scaled price adjustments in panel B, or the combination in panel C) against dummies for capital ratio category. (See equations (4), (5), and (6) in text.) The regression disturbances are assumed to consist of a fixed effect that varies across time, a second fixed effect that varies across firms, and a random disturbance term. Amounts reported above represent the mean of the sample-wide fixed effects (for both years and firms), adjusted for the deviation about that mean for the given capital-ratio category.

bNot applicable. The few observations in this cell were included within the category labeled as 9-11%. cTotal mark-to-market accruals consist of price adjustments minus loan loss provisions, both scaled by total assets.


errors is a concern, indicate significant differences between groups; the comparable t-statistics based on time-series standard errors are not close to achieving significance. In light of this finding and the previously discussed measurement error bias in the direction found in panel B, we hesitate to rely on the results from the full-sample pooled regression. Thus, we conclude there is no reliable evidence that price adjustments are manipulated to allow Danish banks to avoid regulatory intervention. Results based on an 8% cutoff for low-category banks are similar.

Tests for Manipulation of Net Effect of Loan Loss Provisions and Price Adjustments. Table 4, panel C presents the results of tests for the sum of loan loss provisions and price adjustments, scaled by total assets. Since the price adjustments are more variable than the loan loss provisions, the results are similar to those based on price adjustments alone. There is a significantly lower combined accrual for the medium and high capital ratio banks when the full sample is analyzed with the pooled regression, but not otherwise. For the reasons discussed above, we hesitate to rely on the full-sample pooled regressions. We find no significant differences across the groups when we rely on the time- series t-test that is relatively free of bias in standard errors.

6.3 SUMMARY OF TESTS FOR MANIPULATION OF MARK-TO-MARKET ADJUSTMENTS

Our tests yield no reliable evidence that price adjustments are manipulated by Danish banks. This result is expected, because price adjustments are largely determined by publicly observable market prices. For the other major mark-to-market adjustment-loan loss provisions-we find some mixed evidence of manipulation. Specifically, as in the U.S. system, discretionary loan loss provisions of Danish banks are serially correlated (but only in the full sample), consistent with a gradual recognition of the effects of changes in market values. For the subsample of six large banks, there is also evidence that loan loss provisions are managed to offset the impact of price adjustments and thus dampen the volatility of earnings. However, the key regulatory concern is that managers might manipulate loan loss provisions to avoid capital deficiencies and the associated government intervention. On this score, our tests produce no reliable evidence of manipulation.

7. Evidence on "Noise" in Mark-to-Market Numbers, Based on Comparisons with Stock Prices

We argued earlier that an ideal accounting system for a deposit- guarantee system produces an independently verifiable net-asset balance representing the "bid" obtainable from external parties in an orderly sale or liquidation. In such a system, the book value of net assets would differ from the institution's stock price for only two reasons. First, the stock price but not the net assets would include the value of the


option to "put" the deposits to the guarantee system (Merton [1977] ).27 Second, an ideal accounting system would reflect values based on information that could be revealed to and verified by an auditor, even though the stock market might not yet recognize such values.

In practice, large deviations could also arise in a market-to-market system between net asset values and stock prices because of perceived manager manipulation of accounting, or incompleteness in the mark- to-market system. In the Danish system, for example, there is no attempt to measure the current market value of intangible assets such as core deposits.

Here, we assess the importance of "noise" in mark-to-market accounting numbers by comparing mark-to-market net asset values with stock prices.28 The approach relies on the assumption that deviations of net asset values from stock prices caused by the put option and information asymmetry between managers/auditors and investors would be relatively small.2 Under that assumption, the ratio of stock prices to book values from the ideal mark-to-market accounting system would be close to one. Deviations from one indicate imperfections in the mark-to-market system.

We examine market-to-book ratios for both Danish banks and U.S. banks and thrifts. Given that U.S. banks and thrifts do not attempt to reflect current market values in their accounting systems, one would expect large deviations from one in their market-to-book ratios. How- ever, given that both systems ignore the value of important intangible assets, and both systems are subject to manipulation, it is not immediately obvious that market-to-book ratios would be more tightly distrib- uted around one in Denmark. We would prefer to compare the U.S. ratios with Danish ratios calculated with and without mark-to-market

27 Note that since the value of this put option increases with the riskiness of the institution, including it in regulatory capital would encourage the institution to increase exposure to risk; this is one of the reasons stock prices would be poor measures of capital in a deposit-insurance system.

28A critical assumption in our analysis is that U.S. and Danish stock markets are efficient, and that Danish investors gain access to information beyond the financial statements, so that they need not base prices only on book values. There is substantial evidence on the efficiency of U.S. stock markets; we are, however, unaware of any systematic research on the efficiency of the Danish stock market. The evidence on market-to-book ratios becomes difficult to interpret if the Danish market is not efficient.

29A partial test of the assumption that the put option value has little impact on market/book ratios was conducted by examining U.S. thrifts, which include poorly capitalized institutions for whom the put option value was most likely to be large. If the put option value is important, then the market/book ratio should be higher and more variable for thrifts with low capital ratios. However, the market/book ratio for that half of the sample with the lowest capital ratios was actually lower in each year, and the standard deviation was lower in five of eight years-consistent with a small put option value relative to other factors that affect market/book ratios.


TABLE 5 Level of and Dispersion in Market-to-Book Ratios for Banks and Thrifts:

A Comparison of Denmark and United States 1983-90

1983 1984 1985 1986 1987 1988 1989 1990 Average

Market/Book Ratios for Danish Banks Sample Size 49 49 51 51 51 52 55 51 51 Median .93 .79 1.08 1.08 1.13 1.04 .95 .88 .99 Mean .95 .85 1.16 1.19 1.20 1.09 1.02 .97 1.05 t-Test: Mean vs. One -1.59 -4.38* 3.46* 2.56* 3.40* 2.40* .49 -.54 NR**

Standard Deviation .22 .24 .33 .53 .42 .27 .30 .40 .34 Standard Deviation

about One .23 .28 .37 .56 .47 .28 .30 .40 .36 Market/Book Ratios for U.S. Banks

Sample Size 150 150 150 150 150 150 150 150 150 Median .93 1.09 1.58 1.50 1.25 1.22 1.11 1.03 1.21 Mean .98 1.21 1.63 1.60 1.27 1.30 1.18 1.04 1.28 t-Test: Mean vs. One -.84 5.14* 12.86* 10.97* 6.48* 7.82* 4.50* 1.06 NR**

Standard Deviation .29 .50 .60 .67 .51 .47 .49 .46 .50 Standard Deviation

about One .29 .54 .87 .90 .58 .56 .52 .46 .59 F-Test: Variance vs.

Variance for Denmark 1.71# 4.28# 3.26# 1.58# 1.46 2.99# 2.64# 1.31 NR**

Market/Book Ratios for U.S. Thrifts Sample Size 31 38 43 48 55 52 48 39 44 Median 1.02 .80 .99 .87 .57 .55 .59 .30 .71 MeAn 1.18 1.01 1.34 .93 .62 .58 .76 .40 .85 t-Test: Mean vs. One 1.35 .07 1.92 -1.13 -6.71* -5.82* -1.30 -8.92* NR**

Standard Deviation .74 .84 1.16 .43 .42 .52 1.28 .42 .73 Standard Deviation

about One .76 .84 1.21 .44 .57 .67 1.30 .73 .81 F-Test: Variance vs.

Variance for Denmark 11.45# 12.32# 12.40# .66 1.00 3.71# 18.25# 1.11 NR**

*Statistically significant at .05 level (two-tailed test). t-test for average level of mean not calculated, due to lack of independence in data across years.

#Statistically significant at .05 level. **t-test and F-test for overall test period not reported, due to lack of independence in data across years.

adjustments, so as to separate the impact of those adjustments from other factors. However, since Danish banks report only the adjusted figures (no historical cost balances), that is not feasible.

Table 5 presents the distribution of market-to-book ratios for all Dan- ish banks at the end of each year from 1983 through 1990. (All Danish banks have publicly traded stock; none of the savings banks do.) This distribution is compared to that for U.S. banks (from Barth's [1994] study of 150 primarily U.S. banks on the 1990 Compustat Annual Bank Tape) and for all U.S. thrifts (SIC 6035 and 6036) listed on Compustat for the same period.

Table 5 documents that the cross-sectional average market-to-book ratio for Danish banks varies from .85 to 1.20, with a grand mean of 1.05. For the U.S. banks, the annual means range from .98 to 1.63, with


a grand mean of 1.28; annual means for the U.S. thrifts range from .40 to 1.34, with a grand mean of .85. The means are significantly different from one in most years for each sample. While these differences proba- bly reflect the failure of both accounting systems to record the value of intangibles, the differences in the United States perhaps also reflect a failure to record existing assets and liabilities at market values. Such a failure is also a possibility in the Danish data, to the extent that the mark-to-market numbers are manipulated.

Perhaps the most interesting finding in table 5 pertains to the dispersion of market-to-book ratios. For each sample, table 5 presents the standard deviation of market values around the annual mean, as well as the standard deviation about one. In every year but one, for all measures of standard deviation, the amounts for the U.S. banks and U.S. thrifts exceed those for the Danish banks. For the Danish banks, the average annual standard deviation is .34 and the average annual standard deviation about 1.00 is .36; the comparable amounts for U.S. banks are .50 and .59, and for United States thrifts are .73 and .81. The differences are statistically significant in most years.

Under our assumptions, the greater dispersion in market-to-book ratios in the United States can arise because the current value of unrecorded intangibles is more variable in the United States than in Den- mark and/or recorded book values deviate from externally perceived market values more in the United States than in Denmark. The first source of dispersion is not due to the accounting system, but the second represents dispersion that the Danish system is intended to mitigate or eliminate. Given the absence of data on unrecorded intangibles, it is impossible to separate these two possibilities. However, to the extent that the second reason plays any material role, the findings suggest that the mark-to-market accounting numbers in Denmark contain less noise as indicators of the value of recorded assets than the historical accounting numbers in the United States. This conclusion goes against the hypothesis that the subjectivity involved in mark-to-market accounting produces even noisier measures of value than a historical-cost system.

8. The Danish Experience with Regulatory Intervention

Several of the key questions about mark-to-market accounting concern its impact on the cost of resolving capital deficiencies. From 1985 through 1990, 9 banks and 16 mutual savings banks in Denmark experienced capital deficiencies that gave rise to government intervention. Table 6 lists the 9 banks subject to intervention. Since those banks were publicly traded, it is possible to compare the proceeds (if any) received by owners at the time of intervention to the final reported book value of each failed institution. (The acquirers of the 16 failed mutual savings banks paid for such acquisitions in the form of cash infusions to trusts for depositors, but the amounts of the infusions are not available.)


TABLE 6 Resolution of Failed Danish Banks and Savings Banks:

Final Book Value and Price/Cost of Disposition

(1) (2) Year of Last Reported Valuea at (3) Capital Book Value/ Disposition/ Ratio of

Institution Deficiency Total Assets Total Assets (2) to (1)

Banks Closed (2): 6.juli Banken 1987 5.6% 0.0 0.0 C&G Banken 1987 -8.8 0.0 NM

Banks Merged (7): Kronebanken 1986 -4.3 8.8 NM

Hellerup Bank 1987 3.7 13.2 3.6 Faellesbanken 1987 5.9 NA NA

Arhus Discontobank 1987 4.8 15.8 3.3 Bendix Bank 1987 NA NA NA

H&L Banken 1988 7.4 20.7 2.8 Holstebro Bank 1988 7.4 13.8 1.9

Median: 5.6% 13.2% 2.4

Mutual Savings Banks Merged (16): The sixteen mutual savings banks that failed during this period were all placed under the control of other institutions which, in turn, agreed to infuse undisclosed amounts of cash into trusts for depositors.

aValue at disposition is the purchase price of the institution upon merger, or zero for closed banks. Source: Personnel and Yearbooks at the Danish Financial Supervisory Authority.

The first lesson to be drawn from table 6 concerns the costs of early regulatory intervention. Recall that Seidman [1991] estimates that the mere act of government intervention in the United States may destroy as much as 15% of the value of a financial institution's assets. An alternative explanation is that intervention precipitates recognition of market-value losses not yet apparent in the U.S. historical-cost accounting system. The experience with the Danish system provides an opportunity to discrimi- nate between these two possibilities.

Danish bankers and regulators we interviewed indicated that not only were 23 of 25 failed banks and savings banks sold at a positive price, but in most cases they were sold at a premium over book value. For the seven banks sold, data are available in five cases, and as shown in table 6, each was sold at a premium to book value.30 Unless the preintervention values of these failed banks were even higher, the data suggest that regulatory intervention need not destroy significant value, and that Seidman's

30 Compare this finding with the experience of the FDIC with failed banks in the United States: Prior to the Deposit Insurance Reform Act of 1991, FDIC standard practice was to close banks when their book-value capital or net worth reached zero. However, for 1,000 banks that failed between 1985 and 1991, the average loss to the FDIC was 27% of the book value of the failed bank's assets. See Merton and Bodie [1993, n. 25].


[1991] estimated cost of intervention may simply reflect (at least in part) the U.S. accounting system's lag in recognizing value changes.31

Table 6 also provides evidence corroborating the previous finding that mark-to-market accounting numbers are not manipulated to avoid regulatory intervention. Acquisitions at a premium over book value suggest that the book values are not significantly overstated at the time of intervention. On the contrary, if the premia reflect unrecorded intangible assets of the failed banks, as opposed to synergies, the evidence suggests that incompleteness in the Danish accounting system causes book values to be downward-biased indicators of market value.

Given that only one of the 25 cases of regulatory intervention involved government financial assistance, the costs of dealing with capital deficiencies in Denmark appear low, especially relative to the U.S. experience. One might argue that Denmark has avoided such costs by acting too quickly, requiring takeovers of banks that could have survived without intervention. However, given that the owners of the failed banks chose to forego the option to remedy the capital deficiency through cash infusions, and instead sold their shares to acquiring firms, the evidence does not suggest that the interventions were costly and premature.32

9. Summary and Lessons for the United States

This paper examines the Danish experience with mark-to-market accounting for banks to help resolve some of the questions raised as the United States considers the merits of such a system for financial institutions.

Our first result concerns the reliability of mark-to-market accounting systems, particularly their susceptibility to management manipulation. We find no compelling evidence in the Danish system that price adjustments, which include the major realized and unrealized gains and losses on investments and some off-balance sheet positions, are manipulated. We do find evidence of a gradual recognition of loan losses, similar to that documented for the U.S. banking sector. This result provides justification for the concern that mark-to-market accounting for loans in Denmark does not entirely overcome managers' tendency to delay reporting of credit risks. Nevertheless, on the key question of whether the mark-to-market accounting system is managed to avoid regulatory intervention, our tests produce no reliable affirmative evidence.

31 In principle, another possibility is that book values increased substantially after the

final report but prior to acquisition. While we have no data to refute this possibility, our discussions with the Danes cast extreme doubt on it.

32 It would be interesting for future research to compare the performance of the Dan- ish banking system with the performance of the banking systems in Norway and Sweden. The three countries have closely related economies and all of them have experienced economic downturns in the past few years. However, only Danish regulations use a mark- to-market accounting system.


We found other indications that the Danish mark-to-market accounting system produces numbers that are more reliable indicators of value than the historical-cost numbers reported in the U.S. system. First, stock prices track book values more closely for Danish banks than for either U.S. banks or U.S. thrifts. Second, in contrast to the U.S. experience, banks sold as a result of regulatory intervention have typically fetched prices close to or higher than final reported book value. Thus, even institutions vulnerable to intervention, which presumably have strong incentives to overstate net assets, report values that are, if anything, conservative estimates of selling prices.

Our second result concerns the importance of regulatory intervention policy. The Danish system combines mark-to-market accounting with rigid regulatory intervention policies; both may have contributed to the relatively low costs of resolving bank failures. As argued by Beaver, Datar, and Wolfson [1992] and Benston and Kaufman [1988], absent a credible commitment of regulators to act on capital deficiencies, mark-to-market accounting would not necessarily lead to this outcome.

Our third result concerns volatility; we find that earnings for Danish banks are three to four times more variable after mark-to-market adjustments than before. The added variability is driven primarily by gains and losses on unhedged investments in long-term, fixed-rate bonds. Whether a shift to mark-to-market accounting in the United States would also increase earnings variability depends on whether such investments, as well as fixed-rate loans (uncommon in Denmark) are well hedged, and whether the hedges-including long-term liabilities-are also marked to market. Greater volatility could lead to maintenance of greater equity "cushions," a common practice among small Danish banks. That practice certainly involves opportunity costs, but it may represent a relatively efficient solution for dealing with the conflicts of interest that inevitably arise between guarantors and the guaranteed.

There are vast differences between Denmark and the United States in the number of banks and the complexity of their asset structures. Fur- ther, political, regulatory, and auditing environments in the two countries differ substantially. Therefore, one must be cautious in evaluating the relevance of the Danish evidence to the U.S. policy debate. Subject to this caveat, the evidence reported in this paper lends support to the proponents of mark-to-market accounting for financial institutions.

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Documents

Accounting Research Center, Booth School of Business ...€¦ · AND KRISHNA G. PALEPUt 1. Introduction Proponents of a mark-to-market accounting system for U.S. banks and thrifts