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Jannis Bischof, Mannheim / Ulf Brüggemann, Lancaster / Holger Daske, Mannheim *

Jannis Bischof, Mannheim / Ulf Brüggemann, Lancaster / Holger Daske, Mannheim *. Relaxation of Fair Value Rules in Times of Crisis: An Analysis of the Economic Benefits and Costs of the Amendment to IAS 39 INTACCT Paris 1 July 2010. * Area of Accounting & Taxation University of Mannheim

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Jannis Bischof, Mannheim / Ulf Brüggemann, Lancaster / Holger Daske, Mannheim *

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  1. Jannis Bischof, Mannheim / Ulf Brüggemann, Lancaster / Holger Daske, Mannheim * Relaxation of Fair Value Rules in Times of Crisis:An Analysis of the Economic Benefits and Costs of the Amendment to IAS 39INTACCT Paris1 July 2010 * Area of Accounting & Taxation University of Mannheim D-68131 Mannheim Tel.: +49 (0)621 181 2352 Fax: +49 (0)621 181 1694 E-mail: daske@bwl.uni-mannheim.de

  2. Relaxation of Fair Value Rules: Introduction Setting • In the heat of the financial crises, in October 2008, the IASB forwent any regular due process to issue emergency amendments to IAS 39 and IFRS 7 • Option to retroactively reclassify financial assets previously measured at fair value into amortized costs, i.e. suspend fair value measurement (“reclassifications”) • Option introduced under severe political pressure, most notably from EU leaders, e.g. French President Nicolas Sarkozy • Banks make ample use of option to forgo substantial write downs • E.g., Deutsche Bank boost income by 3.2bn Euro INTACCT Paris, 1 July 2010 Bischof / Brüggemann / Daske

  3. Relaxation of Fair Value Rules: Introduction Motivation • Official reasoning: Competitive disadvantages vis-à-vis U.S. banks due to reclassification options in SFAS 65 & 115 • Amendment was probably politically perceived as cheap way to put pressure off the banking sector due to link between accounting numbers and regulatory capital • Two alternative political strategies • Relaxation of regulatory capital requirements • Relaxation of accounting rules • We investigate key economic consequences of the decision to relax fair value rules INTACCT Paris, 1 July 2010 Bischof / Brüggemann / Daske

  4. Relaxation of Fair Value Rules: Introduction Analyses and Results (1) • Descriptive evidence on reclassification choice and effects • Economic and political drivers of the reclassification choice • Stock price reactions to reclassification announcements • Expected reclassification effects around regulatory events • Realized reclassification effects around firm-specific announcements • Long-term effects on information asymmetry INTACCT Paris, 1 July 2010 Bischof / Brüggemann / Daske

  5. Relaxation of Fair Value Rules: Introduction Analyses and Results (2) • 41% of IFRS banks reclassify, saved profits 22bn Euros in total, only 1/3 in full compliance with IFRS 7 requirements • Choice can be traced to regulatory costs, political costs, …, • At least some banks benefit from reclassifications by avoiding fair value write-offs and, thus, forgoing regulatory costs (contracting role of fair value accounting) • In the long run, the suspension of fair value accounting comes at the cost of greater adverse selection if disclosure requirements are not complied with (informational role of fair value accounting) INTACCT Paris, 1 July 2010 Bischof / Brüggemann / Daske

  6. Relaxation of Fair Value Rules: Introduction Contribution • Regulatory debate: Relaxation of capital requirements vs. change of accounting standards (Laux/Leuz 2009; Bushman/Landsman 2010, Barth/Landsman 2010 - Skinner 2008, Bernard et al. 1995) • Analyze the effects of the link between regulatory capital and fair value accounting under IFRS in a cross-country setting • Politics of standard setting (e.g. Watts/Zimmerman 1986) • Informational role of fair values (e.g. Barth et al. 1996) • Decrease vs. increase in fair value information • Reliability concerns more severe internationally • Comprehensive & hand-collected international dataset onfair values measurement, reclassification, and regulatory capital INTACCT Paris, 1 July 2010 Bischof / Brüggemann / Daske

  7. Relaxation of Fair Value Rules: Institutional Background Sequence of Regulatory Events Leading up to the IAS 39 Amendment • Summer 2008: Large banks lobby against fair value rules, strong opposition by IASB • September 2008: US Congress grants SEC right to suspend fair value accounting • October 4, 2008: Barroso, Berlusconi, Brown, Merkel, Sarkozy call for reclassifications • October 7, 2008: ECOFIN supports reclassifications • October 8, 2008: Commissioner McCreevy announces that the EU is ready to adopt its own version of IAS 39 • October 9, 2008: IASCF Trustees renounce due process • October 13, 2008: IASB adopts reclassification amendments • October 15, 2008: Official endorsement of the amendments in the EU (other jurisdictions follow over the next days) INTACCT Paris, 1 July 2010 Bischof / Brüggemann / Daske

  8. Relaxation of Fair Value Rules: Institutional Background The Newly Introduced Reclassification Rules • IAS 39 measurement-basis: FV through P&L, FV through OCI, Amortized cost – categorization at initial recognition of financial asset • Types of IAS 39 reclassifications: INTACCT Paris, 1 July 2010 Bischof / Brüggemann / Daske

  9. Relaxation of Fair Value Rules: Institutional Background The Newly Introduced Reclassification Rules • The IAS 39 amendments are accompanied by extensive disclosure requirements in IFRS 7 • Quantitative disclosures • amounts reclassified for each measurement category • current fair values • fair value gain or loss before reclassification • effect on net income and OCI • effective interest rate and recoverable amounts • Qualitative disclosures (6) facts and circumstances of the rare situation INTACCT Paris, 1 July 2010 Bischof / Brüggemann / Daske

  10. Relaxation of Fair Value Rules: Conceptual Underpinnings Motivation • What are the economic consequences (from an equity investor’s point of view)? Economic Benefits Economic Costs • Avoidance of regulatory costs during crisis:Determination of regulatory capital is linked to IFRS-based accounting numbers • Long-term increase in intransparency / opacity:FV information is useful (relevant) for financial analysis  Contracting role of fair value accounting  Informational role of fair value accounting INTACCT Paris, 1 July 2010 Bischof / Brüggemann / Daske

  11. Relaxation of Fair Value Rules: Conceptual Underpinnings Hypotheses • The reclassification probability increases with the size of a bank’s incentives to avoid regulatory costs, political costs, and a loss of customer deposits and decreases with the bank’s prior commitment to transparency • Abnormal stock returns are positively associated with the size of the bank-specific reclassification benefits which are • expected around regulatory events • realized around firm-specific announcements • Information asymmetry in the long term is increasing if banks reclassify, but do not provide full disclosures INTACCT Paris, 1 July 2010 Bischof / Brüggemann / Daske

  12. Relaxation of Fair Value Rules: Data Sample • Global sample of all listed IFRS banks • 302 banks with English, Chinese, French, and German language reports (39 countries) • Approx. 90% of market capitalization of all listed IFRS banks • Manual collection • IAS 39 reclassification amounts for each financial instrument category • IFRS 7 notes disclosures • Effect on regulatory capital • Announcement dates • Country variables (political FV debate, capital regulation, institutions) INTACCT Paris, 1 July 2010 Bischof / Brüggemann / Daske

  13. Relaxation of Fair Value Rules: Descriptive Evidence Accounting Effects of Fair Value Reclassifications • Reclassification choice INTACCT Paris, 1 July 2010 Bischof / Brüggemann / Daske

  14. Relaxation of Fair Value Rules: Descriptive Evidence Accounting Effects of Fair Value Reclassifications • Effect on net income (% of variable before reclassifications) • Effect on capital (% of variable before reclassifications) INTACCT Paris, 1 July 2010 Bischof / Brüggemann / Daske

  15. Relaxation of Fair Value Rules: Analysis Economic Determinants at the Firm Level • Capital management incentives Unrealized FV changes (IFRS) … Inclusion in regulatory capital … Tier 2 Tier 1 INTACCT Paris, 1 July 2010 Bischof / Brüggemann / Daske

  16. Relaxation of Fair Value Rules: Analysis Economic Determinants at the Firm Level • Capital management incentives Unrealized FV changes (IFRS) … Inclusion in regulatorycapital … Country-specific minimum capital ratio Country-specific haircut on unrealized FV gains(“prudential filter”) Tier 2 Tier 1 INTACCT Paris, 1 July 2010 Bischof / Brüggemann / Daske

  17. Relaxation of Fair Value Rules: Analysis Economic Determinants at the Firm Level • Minimum capital ratio (total capital) • 8% (Basel II): 27 countries • 10%: 7 countries • 12%: 5 countries • AFS haircuts (debt securities) • Average: 61% • Minimum: 0% (8 countries) • Maximum: 100% (3 countries) • Additional tax haircuts in 12 countries INTACCT Paris, 1 July 2010 Bischof / Brüggemann / Daske

  18. Relaxation of Fair Value Rules: Analysis Economic Determinants at the Firm Level • Additional explanatory factors INTACCT Paris, 1 July 2010 Bischof / Brüggemann / Daske

  19. Relaxation of Fair Value Rules: Analysis Economic Determinants at the Firm Level: Results INTACCT Paris, 1 July 2010 Bischof / Brüggemann / Daske

  20. Relaxation of Fair Value Rules: Analysis Stock Market Reactions (Short-term): Regulatory Events • The univariate analysis of abnormal stock market returns around regulatory events leading to the IAS 39 / IFRS 7 amendments is severely confounded • simultaneous economic stimulus packages • extraordinary volatility • extremely short time-frame • In the cross-sectional analysis, we can control for investor’s expectations • about a bank’s reclassification choice- perfect foresight assumption vs.- prediction model (based on determinants analysis) • About bank-specific benefits from avoiding regulatory costs INTACCT Paris, 1 July 2010 Bischof / Brüggemann / Daske

  21. Relaxation of Fair Value Rules: Analysis Stock Market Reactions (Short-term): Regulatory Events INTACCT Paris, 1 July 2010 Bischof / Brüggemann / Daske

  22. Relaxation of Fair Value Rules: Analysis Stock Market Reactions (Short-term): Regulatory Events INTACCT Paris, 1 July 2010 Bischof / Brüggemann / Daske

  23. Relaxation of Fair Value Rules: Analysis Stock Market Reactions (Short-term): Regulatory Events INTACCT Paris, 1 July 2010 Bischof / Brüggemann / Daske

  24. Relaxation of Fair Value Rules: Analysis Stock Market Reactions (Short-term): Firm-specific Announcements • Firm-specific announcement resolves the remaining uncertainty about the banks’ accounting choices as well as the resulting effects on accounting numbers and, thus, regulatory capital • Therefore, we can replace our proxies for investor expectations by the realized effects INTACCT Paris, 1 July 2010 Bischof / Brüggemann / Daske

  25. Relaxation of Fair Value Rules: Analysis Stock Market Reactions (Short-term): Firm-specific Announcements INTACCT Paris, 1 July 2010 Bischof / Brüggemann / Daske

  26. Relaxation of Fair Value Rules: Analysis Stock Market Effects(Long-term): Information Asymmetry • Dependent variable = bid/ask spread • Independent variables • Reclassification dummy • Magnitude of reclassification is captured by the effect on net income • Disclosure quality is proxied for by compliance with all six requirements laid out in IFRS 7 • Differences in differences design INTACCT Paris, 1 July 2010 Bischof / Brüggemann / Daske

  27. Relaxation of Fair Value Rules: Analysis Stock Market Reactions (Long-term): Information Asymmetry INTACCT Paris, 1 July 2010 Bischof / Brüggemann / Daske

  28. Relaxation of Fair Value Rules: Summary Implications and Conclusions • During the crisis, the relaxation of fair value rules granted crises-effected banks regulatory forbearance • Short-term benefits may come at long-term costs • Reclassifications increase opacity if they are not accompanied by full disclosures • Interference of EU into IASB standard setting process poses major obstacle to convergence with U.S. going forward • Alternative: relaxation of capital requirements • But more complex coordination process, unlike IFRS,banking regulation nationally regulated INTACCT Paris, 1 July 2010 Bischof / Brüggemann / Daske

  29. Relaxation of Fair Value Rules: Back-Up Back-Up INTACCT Paris, 1 July 2010 Bischof / Brüggemann / Daske

  30. Relaxation of Fair Value Rules: Back-Up Economic Determinants at the Firm Level Global Issues in Accounting, 4 June 2010 Bischof / Brüggemann / Daske

  31. Relaxation of Fair Value Rules: Back-Up Stock Market Reactions (Short-term): Firm-specific Announcements Global Issues in Accounting, 4 June 2010 Bischof / Brüggemann / Daske

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