Abstract

Does the use of forward-looking information in banks’ financial reporting enhance financial stability? The answer is no. We exploit the introduction of forward-looking reporting rules in Germany (i.e., IFRS 9) to investigate banks’ loss recognition and lending around the adoption of the new rules. We find that banks strategically adjust the internal ratings of their borrowers such that they minimize loan loss provisions. We do not observe similar rating adjustments for the same borrower by banks that are not applying the new reporting standards. Furthermore, banks tend to trade those loans that would require higher loss recognition and simultaneously acquire loans that are of the same credit risk but require lower loss recognition. Counter to the intended effects of the regulation, banks do thus use the rules to minimize the reserves that would be available to absorb losses in a future crisis, without reducing the overall risk of their loan portfolio. Against this background, we simulate the impact of an economic crisis on banks’ pre-pandemic loan portfolios under the new reporting standards. The interaction of risk-based capital requirements and forward-looking loss provisioning further amplifies the procyclicality of capital requirements with potentially detrimental consequences for financial stability.