Abstract
Accounting principles state that the net presentation of offsetting assets and liabilities on the balance sheet is improper unless the right of setoff exists. Derivatives dealers and their frequent counterparties enter into master netting agreements (MNAs) that provide a limited right of setoff that is insufficient (sufficient) for net presentation under IFRS (US GAAP). To remedy this presentation difference, as of 2013, IFRS and US GAAP require dealers to disclose the gross, reported, and net amounts of derivatives assets and liabilities that they present net or present gross but cover under enforceable MNAs. We first study real effects of these mandatory disclosures on dealers’ financial leverage. We posit that dealers prefer market participants to view their leverage as lower. Because the 2013 requirements provide new information for IFRS dealers but not for US GAAP dealers, we hypothesize and show that the requirements induce IFRS dealers to reduce their derivatives leverage by eliminating unnecessary offsetting derivatives and using MNAs more effectively. We hypothesize and show that the requirements have substantially weaker real effects for US GAAP dealers. We then study the usefulness of the disclosures to market participants. Because the right of setoff provided by MNAs does not eliminate all significant risks of the covered derivatives, we hypothesize and provide evidence that dealers’ net derivatives leverage and disclosure quality under the 2013 requirements inform market participants about dealers’ credit risk uncertainty.
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Notes
The right of setoff is the legal right to receive (obligation to pay) the net asset (liability) value upon the close out of a specified set of positions.
Examples of net presentation of assets and liabilities with limited or no right of setoff under US GAAP include the projected benefit obligation and plan assets for defined benefit pension plans under ASC 715–30, operating (short-term) leases under ASC 840 (842), and transfers of financial assets accounted for as sales under ASC 860.
A derivatives dealer is a firm that transacts on both the buy and sell sides of derivatives markets to satisfy customer needs or to trade, thereby earning bid-offer spreads and other types of fee income.
FASB New Release, January 28 2011, https://fasb.org/page/getarticle?uid=fasb_newsrelease01-28-11body_0228221200&isPrintView=true (accessed Oct 1, 2021).
The seller of a CDS provides the purchaser with insurance against default of a referenced financial asset in exchange for up-front or periodic premium payments.
In contrast, dealers’ gross minus net derivatives leverage reflects both the offsetting and non-offsetting portions of the fair values of derivatives that are covered by MNAs. Credit risk uncertainty arising from closing out derivatives upon default under MNAs is logically unrelated to the non-offsetting portion.
We thank the anonymous reviewer for suggesting this analysis.
The early debate is evident in ARB 14 (1942), in particular, in William Paton’s qualified assent and Sidney Winter’s dissent to that standard. The Basis for Conclusions sections of FTB 88–2, FIN 39, and FIN 41 illustrate the more fully articulated debate during the late 1980s and early 1990s.
To illustrate, assume an MNA covers two interest rate swaps with the same fixed and floating rates but differing terms so that the swaps have equal but opposite fair values: (1) a receive-fixed swap with five-year remaining tenor and larger notional amount and (2) a pay-fixed swap with 10-year remaining tenor and smaller notional amount. Despite the contractual similarity and zero net fair value of the two swaps, their transferred interest rate risks do not fully offset. The risk transferred by the first swap dominates that of the second over the first five years, and only the second swap covers the second five years. The coverage of the two swaps under the MNA does nothing to remedy this mismatch of transferred risks.
For example, to adjust the fair values of CDS for the bid-offer spread that CDS dealers would bear were they to exit the CDS they hold, these dealers typically group their derivatives into limited numbers of remaining maturity and credit spread buckets and estimate a valuation adjustment for each two-dimensional bucket based on historical data. They then apply that adjustment to the modeled fair value for the all the CDS in that bucket. A major CDS dealer’s use of this approach appears on p. 31 of https://web.stanford.edu/~jbulow/Lehmandocs/docs/BARCLAYS/LBEX-BARFID%200011765-0011862.PDF (accessed November 4, 2021).
ARB 11 (1942) expressed the first part of this principle without mentioning the right of setoff. Hence the importance of the right of setoff in US GAAP appears to have crystalized sometime between 1942 and 1953. Likely roots of the notion of the right of setoff are the law regarding settlements of partnership and other claims (Zeff 1957), the ability for taxpayers to pay taxes using certain US federal government securities during World War II (ARBs 14 and 43), and the focus on the solvency of banks in the development of US GAAP (Heath 1978).
Koonce et al. (2019) conduct experiments to examine the related issue of linked balance sheet presentation of offsetting assets and liabilities.
The other financial assets and liabilities covered by the 2013 disclosure requirements are all other recognized financial instruments under IFRS (IFRS 7, paragraph 13A) but only repurchase agreements and securities borrowing and lending under US GAAP (ASC 210–20–50-1).
Representative papers in the off-balance-sheet financing literature include Bowman (1980), Ely (1995), and Dhaliwal et al. (2011) examining operating leases; Dhaliwal (1986) and Hsieh and Liu (2021) examining pensions; and Niu and Richardson (2006) and Chen et al. (2008) examining securitizations accounted for as sales.
Compared to our gross minus net derivatives leverage, Neilson et al.’s (2021) offsetable derivatives has the same numerator but a different denominator, total assets rather than tangible common equity.
One way for dealers to reduce offsetting derivatives is to enter into “compression trades” that offset the net exposure created by a set of preexisting trades among counterparties.
We do not expect our tests of H1 or our other hypotheses to be affected by dealers’ implementation of Basel III. In particular, Basel III’s liquidity coverage ratio requirements were issued in January 2013, began to be phased in as of 2015, and were fully phased in by 2019. Since the initial phase-in date follows the effective date of the 2013 requirements by two years, the liquidity coverage ratio requirements should not affect our hypotheses tests.
The effect of the limited and frictional right of setoff provided by MNAs on a dealer’s credit risk uncertainty arises from the probability of default by the dealer’s derivatives counterparties. If we could observe these counterparties, we could incorporate this probability of default in our empirical tests. Unfortunately, these counterparties are not observable.
We do not propose hypotheses about dealers’ gross minus net derivatives leverage, because it includes both the offsetting and non-offsetting portions of derivatives covered by MNAs. Credit risk uncertainty arising from the limited and frictional right of set off under MNAs is logically unrelated to this non-offsetting portion. However, we empirically examine the association of gross minus net derivatives leverage with credit risk uncertainty.
Equation (1) represents the treatment group of IFRS dealers as the benchmark and includes interactions for the control group of US GAAP dealers to capture differences between the two sets of dealers. While atypical, this representation is informationally equivalent to the typical representation and better captures our framing of H1, simplifying the exposition of our tests of that hypothesis.
We measure credit risk uncertainty using CDS spreads because they are unaffected by the term structure of risk-free interest rates (Rathgeber and Wang 2011), CDS sellers assess credit risk better than do bond investors (Hu et al. 2018), and CDS are more liquid than bonds issued by the referenced credits (Coudert and Gex 2010).
The four clauses are XR (no restructuring), CR (old/full restructuring), MR (modified restructuring), and MM (modified-modified restructuring). The relative popularity of these types has varied over time.
https://www.newyorkfed.org/markets/primarydealers (accessed on September 20, 2017).
https://www.afme.eu/en/divisions-and-committees/primary-deals-rates/ and https://www.afme.eu/Membership/Members-Derectory (both accessed on September 20, 2017). Incremental to the primary dealers list, the members list adds four IFRS dealers: Bankia, Belfius, Lloyds, and Nordea.
https://www.ffiec.gov/npw/Institution/TopHoldings (accessed May 2, 2018).
We obtain these data from dealers’ Form 10-K filings if available and Form 20-F filings otherwise. We could not obtain a 2013 filing for Citizens Financial Group, Inc., as it was a subsidiary of RBS until 2014. We merged the data for Unionbancal in 2012–2013 and MUFG Americas Holdings Corporation in 2014–2017 into a single time series under the latter’s name, because MUFG filed under “Unionbancal” through 2013.
We can obtain similar derivatives variables for US GAAP dealers prior to 2012 from their bank regulatory filings. However, our attempt to collect similar variables for IFRS dealers for 2008–2011 yielded 72% missing observations. Why some IFRS dealers disclose these variables during this period generally is unclear, but country-specific accounting rules appear to play a role; for example, UBS, which discloses the variables, presents offsetting derivatives net under Swiss accounting rules and gross under IFRS.
We could not obtain CDS spreads from WRDS Markit for seven dealers: Belfius Bank SA/NV, BOK Financial Corporation, Citizens Financial Group Inc., Comerica Incorporated, Cooperatieve Rabobank U.A., Jefferies Group LLC, and Regions Financial Corporation. In addition, these spreads are only available for part of the sample period for Northern Trust Corporation and Lloyds Banking Group Plc.
We estimate the entropy balancing weights using the Stata package ebalance. See Hainmueller (2012) for discussion of entropy balancing and Shipman et al. (2017), Chapman et al. (2019), McMullin and Schonberger (2020), Kleymenova and Tomy (2020), and Francis and Wang (2021) for recent uses of entropy balancing in accounting research.
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Acknowledgements
We are grateful for helpful comments from an anonymous referee, Anwer Ahmed, Aleksander Aleszcyk, Gauri Bhat, Yiwei Dou, Gerald Lobo, Jed Neilson, Scott Richardson (editor), Dushyant Vyas, Philip Wang, Biqin **e, and Steve Zeff.
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Appendices
Appendix 1 Sample disclosures for IFRS and US GAAP dealers from 2013 annual reports
IFRS Dealer Example: UBS Group AG
US GAAP Dealer Example: JPMorgan Chase & Co.
Appendix 2 Definitions of variables
Variable | Description | Source |
|---|---|---|
Derivatives variables | ||
GroDerAss (GroDerLiab) | Fully gross fair value of derivative assets (liabilities) before any netting | Post-2013 disclosure requirements Hand collected (see Fig. 1) |
GroMinRepDerAss (GroMinRepDerLiab) | Fair value of derivative assets (liabilities) netted on the balance sheet in accordance with applicable balance sheet presentation requirements | |
RepDerAss (RepDerLiab) | Fair value of derivative assets (liabilities) reported on the balance sheet | |
RepMinNetDerAss (RepMinNetDerLiab) | Fair value of derivative assets (liabilities) subject to enforceable MNAs but not netted on the balance sheet, including financial collateral | |
NetDerAss (NetDerLiab) | Fully net fair value of derivative assets (liabilities) | |
Leverage measures and components | ||
TAss | Total assets minus intangibles (data52500) | Bankfocus following Blankespoor et al., (2013) |
TCE | Shareholders equity (also book value) minus intangibles minus preferred equity (data63300 - data52500 - data62100) | |
NonDerLev | (TAss – RepDerAss)/TCE | Hand collected and Bankfocus |
NetDerLev | (NetDerAss)/TCE | |
GroDerLev | (GroDerAss)/TCE | |
NetGroRank | NetDerLev/GroMinNetDerLev | |
Risk variables | ||
CDS1y | One-year CDS Spread in basis points (as Markit includes more than just one spread, we select the spread which is most frequently available per ID based on three criteria: (1) tier group, (2) docclause definition, and (3) currency) | WRDS Markit |
CDS5y | Five-year CDS Spread in basis points (as Markit includes more than just one spread, we select the spread which is most frequently available per ID based on three criteria: (1) tier group, (2) docclause definition, and (3) currency) | WRDS Markit |
CDS1y5y | Ambiguity about credit risk calculated by the ratio of one-year CDS spreads to five-year CDS spreads | WRDS Markit following Duffie and Lando, (2001) and Kim et al., (2013) |
Control variables | ||
Size | Bank size calculated as the natural logarithm of total assets | Handcollected and Bankfocus following Blankespoor et al., (2013) |
ROA | Return on assets calculated as net income divided by total assets (data94300/TA) | Bankfocus following Ahmed et al., (2011) and Blankespoor et al., (2013) |
NPL | Nonperforming loans calculated as total impaired/nonperforming loans divided by total assets (data80380/TA) | Bankfocus following Ahmed et al., (2011) |
Interactive variables | ||
QUAL | Index capturing the quality of disclosures following the 2013 amendment. Values range from 0 to 4 with 0 being the lowest quality and readability of the related offsetting information and 4 being the highest (see Appendix 5). | Hand collection |
US GAAP | An indicator variable that equals one if the dealer reports under US GAAP and zero otherwise | Hand collection |
Docclause | Fixed effects for the four types of restructuring clauses (called doc clauses) in CDS contracts following ISDA, (International Swaps and Derivatives Association, 2014): XR (no restructuring), CR (old/full restructuring), MR (modified restructuring), and MM (modified-modified restructuring). | WRDS Markit following Callen et al., (2009) |
Appendix 3 List of dealers
This table lists the 47 sample dealers, whether they report under IFRS or US GAAP, and the source from which we identified them. We identified each dealer (a subsidiary, legal entity, or holding company related to the ultimate owner that we analyze empirically) from one of three sources: (1) the Association for Financial Markets in Europe’s lists of primary dealers and members (AFME), (2) the New York Federal Reserve’s list of primary dealers (NYFED), and (3) the Federal Financial Institutions Examination Council’s list of holding companies with assets greater than $10 billion, requiring that their ratio of trading derivatives liabilities to trading derivative assets is between 0.80 and 1.20 (indicating that their trading derivatives books are fairly close to matched, consistent with dealing rather than speculating or hedging), the ratio of their trading derivative assets to their total assets exceeds 0.5% (indicating that they do a reasonable amount of dealing), and their ultimate owner reports under US GAAP (FFIEC).
# | Ultimate owner | Accounting | Source |
|---|---|---|---|
1 | ABN AMRO Group N.V. | IFRS | AFME |
2 | Banco Bilbao Vizcaya Argentaria SA-BBVA | IFRS | AFME/ FFIEC |
3 | Banco Santander SA | IFRS | AFME |
4 | Bank of America Corp. | USGAAP | NYFED/ FFIEC |
5 | Bank of Montreal-Banque de Montreal | IFRS | NYFED |
6 | Bank of New York Mellon Corporation | USGAAP | FFIEC AFME (Members) |
7 | Bank of Nova Scotia - SCOTIABANK | IFRS | AFME/ NYFED |
8 | Bankia, SA | IFRS | AFME (Members) |
9 | Barclays Plc | IFRS | AFME/ NYFED/ FFIEC |
10 | Belfius Banque SA/NV-Belfius Bank SA/NV (in October 2011, when Dexia Belgium Bank separated from Dexia) | IFRS | AFME (Members) |
11 | BNP Paribas | IFRS | AFME/ NYFED/ FFIEC |
12 | BOK Financial Corporation | USGAAP | FFIEC |
13 | Citigroup Inc. | USGAAP | AFME/ NYFED/ FFIEC |
14 | Citizens Financial Group Inc. | USGAAP | FFIEC |
15 | Comerica Inc. | USGAAP | FFIEC |
16 | Commerzbank AG | IFRS | AFME |
17 | Cooperatieve Rabobank U.A. | IFRS | AFME |
18 | Crédit Agricole S.A. | IFRS | AFME |
19 | Credit Suisse Group AG | USGAAP | AFME/ NYFED |
20 | Danske Bank A/S | IFRS | AFME |
21 | Deutsche Bank AG | IFRS | AFME/ NYFED/ FFIEC |
22 | Fifth Third Bancorp | USGAAP | FFIEC |
23 | Goldman Sachs Group, Inc. | USGAAP | AFME/ NYFED/ FFIEC |
24 | HSBC Holdings Plc | IFRS | AFME/ NYFED/ FFIEC |
25 | ING Groep NV | IFRS | AFME |
26 | Intesa Sanpaolo | IFRS | AFME |
27 | Jefferies Group LLC | USGAAP | AFME/ NYFED |
28 | JPMorgan Chase & Co. | USGAAP | AFME/ NYFED/ FFIEC |
29 | KeyCorp | USGAAP | FFIEC |
30 | Lloyds Banking Group Plc | IFRS | AFME (Members) |
31 | Morgan Stanley | USGAAP | AFME/ NYFED/ FFIEC |
32 | MUFG Americas Holdings Corporation | USGAAP | FFIEC |
33 | Natixis SA | IFRS | AFME |
34 | Nomura Holdings Inc. | USGAAP | AFME/ NYFED |
35 | Nordea Bank AB (publ) | IFRS | AFME (Members) |
36 | Northern Trust Corporation | USGAAP | FFIEC |
37 | PNC Financial Services Group Inc. | USGAAP | FFIEC |
38 | Regions Financial Corporation | USGAAP | FFIEC |
39 | Royal Bank of Canada | IFRS | AFME (Members)/ NYFED |
40 | Royal Bank of Scotland Group Plc (The) | IFRS | AFME/ NYFED/ FFIEC |
41 | Société Générale SA | IFRS | AFME |
42 | State Street Corporation | USGAAP | FFIEC |
43 | SunTrust Banks, Inc. | USGAAP | FFIEC |
44 | Toronto Dominion Bank | IFRS | NYFED |
45 | UBS Group AG | IFRS | AFME/ NYFED |
46 | UniCredit SpA | IFRS | AFME |
47 | Wells Fargo & Company | USGAAP | NYFED/ FFIEC |
Appendix 4 Dealer heterogeneity
This figure plots, for each of the 47 sample dealers during 2012–2017, the mean of gross derivative liabilities fair value (GroDerLiab) divided by gross derivative assets fair value (GroDerAss), a measure of the matching of their derivatives books, on the vertical axis against the mean ratio of GroDerAss to total assets, a measure of derivatives activity, on the horizontal activity.
Appendix 5 Disclosure quality index
This appendix explains how we developed QUAL, the index of the transparency of dealers’ disclosures under the 2013 requirements that we use in testing H3. QUAL is based on our evaluation of four dimensions of the disclosures in each dealer’s 2017 financial report, because the way in which these disclosures are provided is highly sticky for a given dealer in its 2013–2017 financial reports. We selected these dimensions as capturing the range of the informativeness and readability of dealers’ disclosures from our reading of all of the disclosures in their 2013–2017 financial reports in the process of hand collecting the reported fair value amounts. We frame each of these dimensions as a yes/no question, coding a more transparent disclosure (yes) as one and less transparent disclosure (no) as zero. The table reports the number of dealers, in total and IFRS versus US GAAP, providing disclosure that satisfy each dimension.
QUAL is the sum of our coding of the four dimensions/questions and thus takes a value from 0 (lowest transparency) to 4 (highest transparency).
Dimension/Question | Coding (# of dealers) | ||
|---|---|---|---|
0 (No) | 1 (Yes) | ||
1 | Is the information mentioned as its own subsection in the table of contents of the notes to the financial statements (i.e., is the information easily findable)? | Full: 26 IFRS: 9 US GAAP: 17 | Full: 21 IFRS: 17 US GAAP: 4 |
2 | Is the information provided in structured list or table (i.e., is the information presented in an easily readable/scannable fashion)? | Full: 8 IFRS: 1 US GAAP: 7 | Full: 39 IFRS: 25 US GAAP: 14 |
3 | Is the information for derivatives provided or summarized in a single line (i.e., does the information require pre-processing by the user)? | Full: 10 IFRS: 5 US GAAP: 5 | Full: 37 IFRS: 21 US GAAP: 16 |
4 | Are all five disclosures specified in the 2013 disclosure requirements provided for both financial assets and financial liabilities (i.e., does it provide all required information)? | Full: 6 IFRS: 2 US GAAP: 4 | Full: 41 IFRS: 24 US GAAP: 17 |
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Ryan, S., Seitz, B. Gross versus net balance sheet presentation of offsetting derivatives assets and liabilities. Rev Account Stud 28, 2516–2555 (2023). https://doi.org/10.1007/s11142-022-09704-1
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DOI: https://doi.org/10.1007/s11142-022-09704-1
Keywords
- Derivatives
- Dealers
- Master netting agreements
- Gross versus net balance sheet presentation
- Disclosure
- Real effects
- Credit risk uncertainty