CFA Institute study calls for enhanced loan disclosures to allow investors to compare bank financial statements more effectively

The second part of a CFA Institute study - Financial Crisis Insights on Bank Performance Reporting - reveals systematic differences in how banks disclose fair values of loans and write off bad or “impaired” debt in 16 countries across the EU, the US, Japan, Canada and Australia. The results reflect a disparate range of impairment measurements that cannot only be explained by differences in prevailing economic conditions, and as loans are an important component of bank balance sheets and a key risk, the report recommends improving loan-related disclosures to enhance bank transparency.

Part II of the study, Relationship between Disclosed Loan Fair Values, Impairments and the Risk Profile of Banks, found:

• Negative valuation gaps (where disclosed fair values in the notes are greater than the loan carrying value reported on the balance sheet) were prevalent amongst banks in France, Spain, Italy, Switzerland and the Netherlands. This is in contrast to the positive valuation gaps observed in German and UK banks. 
• A valuation gap ranging from -30% (six year average) for Spanish banks through to 24% for UK banks (see table A). This gap could not be explained on the basis of prevailing economic conditions during the financial crisis, or bank-specific risk as reflected in Credit Default Swap (CDS) spreads and Price-to-Book ratios.
• Loan impairment analysis across 16 countries, over time, contrasts in some cases with a similar analysis of CDS spreads, which in part reflects the credit risk of assets held. This suggests an inconsistent application of impairments accounting standards. 

The study makes three recommendations for accounting standard setters, regulators, and financial statement preparers in order to aid more comprehensive and comparable bank reporting:

1. Enhanced loan fair value disclosures: To help investor make appropriate analytical adjustments. For example, explaining why disclosed fair values that are determined from internal models differ from the amounts reported on balance sheet. 
2. Enhanced loan impairments disclosures: To enable investors to have a greater understanding of the sources of differences in the impairments reported on financial statements. 
3. Strengthened regulatory enforcement: To ensure consistency and comparability of reported financial statement line items and disclosed amounts.

Vincent Papa, CFA, director of financial reporting policy at CFA Institute and author of the report, commented:  

“A sound banking system should be the bedrock of economic recovery and continued efforts to enhance bank transparency are vital to restore investor trust and confidence in the finance sector. The first part of our report emphasised the need to represent the economic value of bank financial assets and to reflect any write-downs on a timely basis in order to make financial statements more informative. In the second part, we focus on one of the most critical issues for investors: the comparability of information. 

“What is striking in our findings is that the valuation gaps (differences between disclosed fair values in the notes and what is reported on balance sheet) cannot be readily explained by the prevailing economic environment in different countries. This suggests that inconsistently determined and incomparable information is reported by banks. There is clearly a need to enhance bank disclosures in order to help investors make like-for-like comparisons between banks. It also heightens the importance of an effective bank asset quality review by the ECB and other national regulators.”  

The findings of Financial Crisis Insights on Bank Performance Reporting align strongly with the purpose of the CFA Institute Future of Finance initiative, which advocates greater transparency and fairness in pursuit of a stronger financial system. CFA Institute recently launched Part I of the study, Assessing the Key Factors Influencing Price to Book Ratios, which evaluates loan impairments which have an effect on Price to Book (P/B) ratios, a key valuation measure of the financial soundness of banks. The study, based on data from 51 major global banks, evaluates P/B trends from 2003 to 2013 and assesses how loan impairments measures, profitability measures, and risk measures, have affected P/B throughout this reporting period. Part I made three policy recommendations for accounting standard setters, regulators, and financial statement preparers: fair value accounting for loans, support for enhanced risk reporting, and improved leverage reporting.