Window Dressing of Financial Leverage - Edward Owensa and Joanna Shuang Wu b

Window Dressing

Definition :

- We define window dressing as a short-term deviation around quarter-end reporting dates of a financial variable from its quarterly average level. 

- The recent financial crisis brought into focus financial institutions’ risk-taking behavior and raised concerns about whether their end-of-quarter balance sheets are fair depictions of the risk levels during the quarter.

(Feltham and Xie, 1994). :

Window dressing is often characterized as an action taken by an agent that "improves the agent's performance measure but contributes little or nothing to the principal's gross payoff"

(e.g., Lakonishok et al., 1991; Musto, 1999; He et al., 2004; Ng and Wang, 2004). :

One stream of research documents that fund managers and institutional investors dress up their quarter-end or year-end portfolio holdings by selling losing stocks and buying winning stocks

Dechow and Shakespeare (2009) :

find that managers time securitization transactions towards the end of the quarter to increase earnings, improve efficiency ratios, and reduce leverage.

Allen and Saunders (1992) :

Find evidence of upward window dressing of bank total assets, which they attribute to managers’ incentives to inflate bank size in order to be viewed as “too-big-to-fail” and/or to enhance managerial compensation and non-pecuniary reputational benefits. (commercial bank data)

Kotomin and Winters (2006),

 on the other hand, argue that the upward window dressing of bank total assets

may be customer-driven rather than a reflection of bank discretion. ( commercial bank data)

Dichev and Skinner, 2002

Note that for firms that currently are not subject to quarterly averages disclosures (non-banks), window dressing is difficult, if not impossible, to detect, potentially giving strong incentives for such behavior. Second, leverage ratios are widely used in debt covenants and often are calculated based on reported GAAP numbers at period end

(Allen and Saunders, 1992).

It is worth noting that extant literature suggests that bank regulators and the SEC have not devoted large amounts of resources to monitor window dressing activities revealed in BHC regulatory filings, or imposed severe penalties when such activities are detected

CONCLUSION :

This study provides the first large sample evidence on the window dressing of financial leverage and the stock market’s reaction to the public release of information that can be used to infer such window dressing. We find evidence of significant downward window dressing of repo and federal funds liability accounts by public bank holding companies, which results in understatements of quarter-end financial leverage that appear material in a substantial fraction of firm-quarter observations, particularly among the largest bank holding companies. We also document a general upward shift of the window dressing measure during the financial crisis of 2007-2009, possibly due to the seize-up of large fractions of the repo market during the crisis, limiting access to this tool for window dressing. We also observe much subdued window dressing activity in the last couple of quarters of the sample, which may be due to heightened media and regulatory attention in recent month curbing such behavior.

We further find that firms with higher financial leverage in the previous quarter havemore repo and federal funds liabilities in the makeup of their total liabilities and are more likely to engage in downward window dressing in these accounts. In addition, we find that firms with more independent boards of directors have less downward window dressing, suggesting strong governance serves to curb such behavior. Finally, we show that the stock market reactsnegatively to information indicating greater downward window dressing in repo and federal funds accounts, consistent with the negative risk implications of such window dressing.

The potential implications of our findings go beyond bank holding companies and the financial industry. For firms that currently are not subject to quarterly averages disclosures (nonbanks), window dressing is difficult, if not impossible, to detect, potentially giving strong incentives for such behavior. These results speak to the new SEC proposed “Short-Term Borrowing Disclosure” rule. In particular, our market tests suggest that investors of firms thatare not currently subject to quarterly average disclosure requirements will likely find the new disclosure under the proposed rule useful. On the other hand, the findings also show that investors are able to extract information from the Y-9C reports presently filed by BHCs, thus the new SEC requirements may not be as incrementally beneficial in their application to banks.

Nara Sumber :

Window Dressing of Financial Leverage .

Edward Owensa and Joanna Shuang Wu b

William E. Simon Graduate School of Business Administration, University of Rochester,

Rochester, NY 14627, United States.