Have SFAS 166 and SFAS 167 improved the financial reporting for securitizations?

• DOI: http://doi.org/10.1111/jbfa.12449
• Date: 01 July 2020
• Author: Minkwan Ahn,Gordon Richardson,Dushyantkumar Vyas,Zahn Bozanic,Yiwei Dou,Samuel B. Bonsall
• Published date: 01 July 2020

DOI: 10.1111/jbfa.12449

Have SFAS 166 and SFAS 167 improved the

financial reporting for securitizations?

Minkwan Ahn1Samuel B. Bonsall IV2Zahn Bozanic3Yiwei Dou4

Gordon Richardson5Dushyantkumar Vyas5

1The University of Hong Kongand

Sungkyunkwan University

2The PennsylvaniaS tate University

3Florida State University

4New YorkUniversity

5University of Toronto

Correspondence

ZahnBozanic, College of Business, Florida State

University,821 Academic Way,Tallahassee,FL

32306-1110,USA.

Email:zahn.bozanic@fsu.edu

Fundinginformation

SocialSciences and Humanities Research Council

ofCanada; KPMG; Canadian Academic Account-

ingAssociation

Abstract

Critics have allegedthat securitization accounting prior to 2010 was

among the causes of the recent financial crisis. In response to this

criticism, the Financial Accounting Standards Board (FASB) imple-

mented two new accounting standards, SFAS 166 and SFAS167, to

improve the financial reporting for securitizations. Bank regulators

have stated their belief that SFAS 166/167 will result in a consoli-

dated balance sheet (and risk-based capital ratios based thereupon)

that better reflects a bank’s exposure to risk related to securitized

assets. We document that, by ceding retained power or influence

through the servicing/special servicing functions to third parties,

SFAS 166/167 resulted in real effects to the extent that banks

(particularly those that were weakly capitalized) achieved their

accounting objectives in the post-SFAS 166/167 period through

legitimate transaction structuring in line with the intent of the new

rules. Further, we use capital market participants’ assessments of

risk retention by sponsoring banks as a benchmark, and provide

evidence consistent with bank regulators’ beliefs. In particular,

following SFAS 166/167, equity investors of sponsoring banks

do not consider (consider) as risk relevant securitized assets that

receive off-balance sheet (on-balance sheet) treatment. Securitized

assets that are consolidated under SFAS 166/167 exhibit the same

risk relevance as assets that are not securitized, despite contractual

provisions that would seem to imply substantial risk transfer.

KEYWORDS

FASB, financial reporting, off-balance sheet, real effects, risk rele-

vance, securitization, securitization accounting, SFAS166 and 167

JEL CLASSIFICATION

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J Bus Fin Acc. 2020;47:821–857. wileyonlinelibrary.com/journal/jbfa c

2020 John Wiley & Sons Ltd 821

822 AHN ET AL.

“The agencies use GAAP as the initial basis for determining whether an exposureis treated as on- or off-balance

sheet for risk-based capital purposes. The agencies have long maintained that a banking organization should

hold capital commensurate with the level and nature of the risks to which it is exposed.As described below, the

agencies believe that the effects of FAS166 and FAS 167 on banking organizations’ risk-based capital ratios will

result in regulatory capital requirements that better reflect, in manycases, banking organizations’ exposure to

credit risk.”

Department of the Treasury, Federal Reserve System, and FDIC (2010)

1INTRODUCTION

The recent financial crisis was one of the most important economic events since the Great Depression of the 1930s.

The pre-crisis era witnessed a rapid growth in securitizations of credit-risky assets such as mortgages and commer-

cial loans. Observers such as the Financial Crisis Inquiry Commission (2011) have argued that the complex structure

of securitizations enabled banks to retain risk in an opaque manner and thus contributed to the crisis. In particular,

banks often structured securitizations using Qualified Special Purpose Entities (QSPEs or simply “Qs”) to ensure off-

balance sheet treatment under the prevailing accounting standards, despite substantial evidence during the pre-crisis

era that sponsors typically retained some degree of exposure to the credit risk of securitized assets through retained

on-balance sheet interests, explicit contractualrepresentations and warranties, and implicit “moral recourse”.1

Critics, such as The President’s Working Group on Financial Markets (2008), have alleged that the securitization

accounting prior to 2010 was among the causes of the recent financial crisis.2Consistent with the overwhelming capi-

tal market-basedevidence concerning risk-retention by sponsoring banks, US bank regulatory agencies have taken the

position that the previous off-balance sheet treatment allowed banks to “obtainlower regulatory capital requirements

without a commensurate reduction in risk” (Department of the Treasury, Federal Reserve System, and FDIC, 2010,

p. 4641).3In response to this criticism and calls for revised accounting standards that better reflect a bank’s exposure

to credit risk related to securitized assets, the Financial Accounting Standards Board (FASB) amended the two stan-

dards that governedaccounting for securitizations, Statement of Financial Accounting Standards (SFAS) 140 and FASB

Interpretation 46R (FIN46R), with two new accounting standards, SFAS166 and SFAS 167 (effective beginning 2010),

to improve the financial reporting for off-balance sheet entities.4We first investigate whether bank sponsors struc-

ture securitizations in the post-SFAS166/167 period to achieve off-balance sheet status for the Special Purpose Entity

(SPE) housing the transferred assets. We then investigate whether the on- and off-balance sheet recognition choices

after SFAS 166/167 better reflect the extentto which sponsoring banks in the US retain the credit risk of securitized

loans.

Prior to the new standards, loan securitizations typically involvedan SPE set up to issue asset-backed securities. The

SPE had to meet certain SFAS 140 tests in order to be deemed a QSPE, and thus become exemptfrom consolidation.

1For evidence consistent with these arguments, see Gorton and Souleles (2005), Niu and Richardson (2006), Landsman, Peasnell, and Shakespeare(2008),

Chen,Liu, and Ryan (2008), Barth, Ormazabal, and Taylor(2012), Dou, Liu, Richardson, and Vyas (2014), Ahn (2014), and Bonsall, Koharki, and Neamtiu (2015).

Standardand Poor’s (2001, p. 106) defines “moral recourse” as “the reality that companies feel that they must bail out a troubled securitization although there

is no legal requirement for them to do so. Companies that depend on securitizations as a funding source may be especially prone to taking such actions. In

manysituations, this expectation undermines the notion of securitization as a risk transfer mechanism”.

2ThePresident’s Working Group recommended the following: “Authorities should encourage FASBto evaluate the role of accounting standards in the current

market turmoil. This evaluation should include an assessment of the need for further modifications to accounting standards related to consolidationand

securitization,with the goal of improving transparency and the operation of U.S. standards in the short-term.”

3Asexplained by Richardson, Ronen, and Subrahmanyam (2011), capital requirements corresponding to the newly issued accounting standards were an impor-

tant and essential component of the Dodd-Frank Act aimed at reforming the banking sector with regards to regulatory arbitrage related to securitization

activities.

4The FASBcodified SFAS 166 and 167 as part of ASC 860-20 and 810-10, respectively. For expositional purposes, in this paper we refer exclusivelyto the

legacynomenclature.

AHN ET AL.823

Not all SPEs were QSPEs and FIN46R guided the consolidation requirements for SPEs other than QSPEs (i.e., variable

interest entities, or VIEs). SFAS166 and SFAS 167 eliminated the concept of QSPEs that were previously exempt from

consolidation. As explained in Deloitte (2014), after the adoption of SFAS 166/167, one first looks to SFAS 167 to

determine whether the VIE receiving the transferred loans must be consolidated. If so, the sale criteria in SFAS 166

becomes redundant for the bank’s consolidated financial statements. SFAS 167 also requires issuers to consider the

former QSPEs as candidates for consolidation on an ongoing basis, depending on the degree of power over the entity

and retained variable interests.

Richardson, Ronen, and Subrahmanyam (2011) describe SFAS 167 as a crucial new accounting standard that will

resultin broader consolidation requirements for securitized assets, with implications for the regulatorycapital of spon-

soring banks. As implied by the opening quotation, in new regulatory capital requirements adopted in 2010, bank regu-

lators will use GAAP-based consolidated assets and liabilities as an initial basis for determining a bank’s minimum risk-

based capital. Despite the stated belief of bank regulators that SFAS167 will result in a consolidated balance sheet (and

risk-based capital ratios based thereupon) that better reflects exposure to credit risk, there is no systematic evidence

showing that the new standards indeed achieve the goal of improvingfinancial reporting for securitizations.

Our study first examines real effects post-SFAS 166/167 by investigatingthe structure of securitizations conse-

quent to the new standards. Namely, do bank sponsors structure securitizations in the post-SFAS166/167 period to

achieve off-balance sheet status for the SPE housing the transferred assets? This question follows from other studies

that have established real effects arising from new accounting standards—effects consistent with a desire of account-

ing standard setters to allow unconsolidated VIE assets only when control and interest are effectively surrendered.

More importantly,as accounting numbers themselves serve as quantitative inputs into regulatory calculations (i.e., to

lower regulatory capital requirements), bank managers also have incentives to obtain off-balance sheet treatment by

changing the structure of securitizations. Thus, one predicted real effect is that, after SFAS166/167, sponsoring banks

will structure securitizations so that they do not retain the role as servicer.

Next, our study examines whether the recognition of VIE assets as either on- or off-balance sheet under the new

GAAP leads to improved regulatory capital measurements (“capitalmarket effects”). In the absence of perfect bench-

marks for the true extent of risk-retention by sponsoring banks, to reliably assess whether regulatory capital calcula-

tions based on amounts reported under SFAS 166/167 reflect the underlying economics of the securitization trans-

actions, we rely on capital market assessments. We appeal to a long line of literature on regulatory usage of market

discipline, in which regulators often look to the capital markets to inform their views regarding supervised banks (e.g.,

Basel Committee on Banking Supervision, 2001; Board of Governors of the FederalReserve System, 1999; Flannery,

2012). Our reliance on capital market assessments of risk-retention is not ad hoc and has conceptual underpinnings in

the literature concerning bank regulators’ reliance on marketdiscipline (Flannery, 2012; Flannery & Nikolova, 2004).5

Thus, if the new accounting standards better reflect risk retention by banks, we would expectto observe the following

patterns in our data: securitized assets that are consolidated by a bank should have demonstrated risk relevance as

perceived by investors; securitized assets that are not consolidated bya bank should have no demonstrated risk rele-

vance as perceived byinvestors; and, finally, there should be no observed difference in the risk relevance of on-balance

sheet securitized assets relative to unsecuritized assets on the balance sheet.

This paper addresses an important controversyin the literature of interest to both US bank regulatory agencies and

the FASB.A major objective of the FASB for the new consolidation model underlying SFAS 166/167 was toachieve on-

andoff-balance sheet recognition choices that better alignwith the extent to which banks retain the risks of securitized

loans. SFAS 167 is explicitthat non-contractual risks (including reputational risk) are to be considered in the decision

to consolidate the assets and liabilities of a securitized entity.In paragraph A58, SFAS 167 states that “when an entity

5Forexample, Flannery and Nikolova(2004) point t o a useful role for marketinformation and state the following: “even if market information cannot systemat-

icallyimprove supervisory assessments of current or future conditions, contemporaneous affirmation of supervisory information can still provide substantial

value. Supervisory judgments can be buttressed bymarket data, provided that market data is properly interpreted.” Flannery (2012) also surveys and opines

on the literature on market discipline of banks and concludes that “Allthings considered, it appears that market information can best be used to reinforce

supervisoryassessments and to constrain the supervisors’ ability to forebear.”