Banks using ‘discretion’ to report loan losses

Financial regulators are allowing banks to use their own discretion in reporting loan losses during periods of industry weakness to temporarily preserve financial stability, a new report has claimed.

A working paper from the Bank for International Settlements entitled Regulatory discretion and banks’ pursuit of “safety in similarity”, found that institutions: “may be permitted to exercise more discretion in their reporting of charge-offs when the banking system is weaker than when the problem is more isolated”.

“Such discretion has the desired effect of at least temporarily preserving financial stability and it may also encourage banks to cluster to gain ‘safety in similarity’. Whether more clustering adds to financial stability is an open question,” the report charges.

The study looked at the annual charge-offs and provisions for loan losses for the 30 largest US banks between 1979 and 2005, and worked off the hypothesis that: “bank regulators grant banks more discretion in reporting charge-offs when the system is weaker” while they are “likely to be less generous with the reporting discretion options that they confer…when the industry is stronger.”

Researchers also found that risk-taking behaviour among banks is largely determined by the behaviour of peer banks and that the ‘clustering’ observed in loss reporting extends into risk appetites.

“In addition we [found] that individual banks detectably change their risk-taking to make it more like that of other banks during periods when the banking industry is weaker,” the paper concludes.

The full report can be found on the Bank for International Settlements’ website: www.bis.org.