Capital Requirements
and
Earnings Management
in Banks
Paris, 2009
Capital Requirements
and
Earnings Management
in Banks
Paris, 2009
Bank’s capital is defined in accounting terms
Book value of equity can deviate significantly from its market value
Risky assets are usually measured by book values (derivatives being the exception)
Accounting numbers can hide (positive
Should Risk Management be Based on Accounting Numbers and Principles ?
Why Should Banks Manage Earnings ?
Why Should Banks Manage Earnings ?
Capital Requirement Analysts’ Expectations
- Return on Assets / Investments - Growth Rate
Methods for Managing Earnings
Methods for Managing Earnings
Big Bath Charges
Creative Acquisition Accounting Cookie– Jar Reserves
Materiality
Accounting Principles
Accounting Principles
Conservative Accounting vs. Transparency Book Value vs. Fair Value
Degeorge, Patel and Zeckhauser (1999)
Degeorge, Patel and Zeckhauser (1999)
Report positive earnings
Sustain recent performance Meet analysts’ expectations
Introduce 3 behavioral thresholds for earnings management:
Return on equity of 15-20%
Sustained earnings, growth of earnings of 5-10% Minimum equity of 8-12% of risky assets.
Maintain credit rating
Over the last decade, leading banks were
Why Should Banks Own Real Assets ?
Why Should Banks Own Real Assets ?
Special Skills
Special Information Economies of Scale Risk Diversification Earnings Management
Hard to sustain excellent performance Hard to achieve growth of earnings Increased equity base requires larger future profits (Unless paid out as
dividends).
A Bank faces the dilemma:
The Model
The Model
Objective Function
- Capital Requirements
- Minimal Return on Equity (e.g. 10%) - Minimize Penalty on Missing Objectives
Constraints
Constraints
RET = PROF/EQT ≥ 10%
Capital Adequacy requirement is 8%
The Model – A Numerical Example
The Model – A Numerical Example
Explicit Asset , A , is binomially distributed with U = 1.1 , D = 1.02 (rf=5%)
Hidden asset , B , has a certain return of 5% (or less) Initial value of A is VIS = 100
Initial value of B is 15 in market value terms, INV = 15
No Action
No Action
25 . 2 = RP % 1 . 9 10 100 115 110 10 15 100 = = = = = = = = MRC EQT DEB EV BV BVL INV VIS 5 . 2 5 . 7 100 5 . 10 75 . 15 97 % 4 . 13 % 55 5 . 5 5 . 15 100 5 . 10 75 . 15 105 − = = = = = = = = = = = = = = PROF EQT DEB BVL INV VIS MRC RET PROF EQT DEB BVL INV VIS 5 . 2 5 . 7 100 5 . 10 75 . 15 97 % 4 . 13 % 55 5 . 5 5 . 15 100 5 . 10 75 . 15 105 − = = = = = = = = = = = = = = PROF EQT DEB BVL INV VIS MRC RET PROF EQT DEB BVL INV VIS 48 . 110 % 4 . 15 % 2 . 143 74 . 10 24 . 18 24 . 118 % 7 . 15 % 2 . 20 14 . 3 64 . 18 64 . 118 % 3 . 21 % 4 . 74 54 . 11 04 . 27 04 . 127 = = = = = = = = = = = = = = = = VIS MRC RET PROF EQT VIS MRC RET PROF EQT VIS MRC RET PROF EQT VIS 5 . 3 − = RP 22 . 3 = RP 66 . 6 = RP 51 . 0 = RPSimple strategy
Simple strategy
25 . 2 = RP % 1 . 9 10 100 115 110 10 15 100 = = = = = = = = MRC EQT DEB EV BV BVL INV VIS 5 . 7 100 5 . 10 75 . 15 97 % 4 . 13 % 55 5 . 5 5 . 15 100 5 . 10 75 . 15 105 = = = = = = = = = = = = = EQT DEB BVL INV VIS MRC RET PROF EQT DEB BVL INV VIS 7 . 8 100 11 . 8 16 . 12 59 . 100 % 4 . 13 % 55 5 . 5 5 . 15 100 5 . 10 75 . 15 105 = = = = = = = = = = = = = EQT DEB BVL INV VIS MRC RET PROF EQT DEB BVL INV VIS % 6 . 15 % 8 . 111 72 . 9 42 . 18 42 . 118 % 7 . 15 % 2 . 20 14 . 3 64 . 18 64 . 118 % 3 . 21 % 4 . 74 54 . 11 04 . 27 04 . 127 = = = = = = = = = = = = = = = MRC RET PROF EQT VIS MRC RET PROF EQT VIS MRC RET PROF EQT VIS 5 . 3 − = RP 22 . 3 = RP 09 . 5 = RP 51 . 0 = RP 3 . 2 − = RPSmart strategy
Smart strategy
25 . 2 = RP % 1 . 9 10 100 115 110 10 15 100 = = = = = = = = MRC EQT DEB EV BV BVL INV VIS 5 . 2 5 . 7 100 5 . 10 75 . 15 97 % 4 . 13 % 55 5 . 5 5 . 15 100 5 . 10 75 . 15 105 − = = = = = = = = = = = = = = PROF EQT DEB BVL INV VIS MRC RET PROF EQT DEB BVL INV VIS 0 . 1 0 . 11 100 5 . 3 25 . 5 5 . 107 % 4 . 13 % 55 5 . 5 5 . 15 100 5 . 10 75 . 15 105 = = = = = = = = = = = = = = PROF EQT DEB BVL INV VIS MRC RET PROF EQT DEB BVL INV VIS 16 . 110 % 8 . 15 % 6 . 70 76 . 7 76 . 18 76 . 118 % 7 . 15 % 2 . 20 14 . 3 64 . 18 64 . 118 % 3 . 21 % 4 . 74 54 . 11 04 . 27 04 . 127 = = = = = = = = = = = = = = = = VIS MRC RET PROF EQT VIS MRC RET PROF EQT VIS MRC RET PROF EQT VIS 5 . 3 − = RP 22 . 3 = RP 03 . 3 = RP 51 . 0 = RP 0 = RPReward/Penalty
Reward/Penalty
2 4 6 8 10 12 1.74 1.76 1.78 1.82Reward/Penalty
Reward/Penalty
2 4 6 8 10 12 1.58 1.62 1.64 1.66 1.681.55 1.6 1.65 1.7 1.75 1.8 1.85
Reward/Penalty comparison
Reward/Penalty comparison
No cost to keep a hidden asset
Is $1 of penalty at time 1 equivalent to potential penalty at time 2 ? No.
PV(Penalty)= 0.595 0 0 0 1
Time 0
1
2
Asset management and liquidation policy can be very effective tools for earnings management.
Analytical solutions for the multi-period case can be quite messy.
Optimal policy depends on the structure of penalties
Missing the target today can be much
