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Banks and Short-term Borrowing
Joanna Shuang Wu
Associate Professor of Accounting
Edward L. Owens
Assistant Professor of Accounting
In 2010, the Wall Street Journal published a series of articles that focused on discretionary actions that 18 big banks take to mask risk. At the end of each quarter, when they were required to report debt levels, the banks were window-dressing their leverage to appear less risky in their borrowing throughout the quarter as a whole, the Journal reported
Simon School professors Joanna Shuang Wu, associate professor of accounting, and Edward L. Owens, assistant professor of accounting, set out to investigate for themselves whether a large sample of bank-holding companies were indeed window-dressing leverage numbers to mask fluctuations during the quarter. They also wanted to see if the market knew—and if it cared.
In their paper, “Window Dressing of Financial Leverage,” the authors studied the use of short-term loans, the tool banks are most likely to use. They find evidence that a large percentage of the companies do pay off short-term loans at the end of the quarter. These loans were repurchase agreements, or repos.
Banks are required to report quarter-end numbers and quarterly averages in Y-9C regulatory filings with the Federal Reserve, but only quarter-end numbers appear in financial statements filed with the Securities and Exchange Commission (SEC). Owens and Wu showed that during the quarter debt levels fluctuate, but they often find their lowest point at the quarter’s end. This means higher debt levels during the quarter are shielded from view, and the quarter’s overall risk appears lower than implied by quarter-end numbers in SEC filings.
They also found that the stock market is paying attention: It responds when banks’ quarterly average leverage figures are published in the Y-9C. “It is an economically significant effect,” Owens says. “You see a stock market reaction when the Y-9C is published. It would have been surprising if we found no stock market reaction.”
In September 2010, the SEC unanimously voted to propose rules requiring both financial and non-financial public companies to provide enhanced disclosure of short-term borrowings.
The reason is rooted in the recent financial crisis, which has brought the risk-taking behavior of financial institutions into sharper focus, the authors write. Short-term borrowing is of particular concern to the SEC for at least two reasons. For one, firms that rely heavily on it are more susceptible to fluctuations in market conditions. Second, because the levels of short-term borrowing can vary greatly during a reporting period, end-of-quarter balances are less likely to accurately represent activities during the period.
The SEC wants greater transparency. Reports that are released to the investing public should have more complete information that makes transactions more obvious, regulators say. And they want more than just banks to cooperate, calling for the regulations to apply to all companies.
“Banks already have to file disclosures,” Owens says. “The stock market responds. The implication is that the market values the in-quarter, short-term borrowing information. And the SEC recognizes that it would be useful if all firms filed disclosures.”
