Accounting for Offsetable Derivatives and Financial Stability

U.S. GAAP allows banks to offset derivative assets against derivative liabilities with the same counterparty and report only the net amount on the balance sheet. Derivatives offsetting under IFRS is much more restrictive, resulting in the single largest difference in balance sheet presentation between U.S. GAAP versus IFRS. Using a global sample of banks, we examine whether the accounting treatment of offsetable derivatives affects investor assessment of bank default risk and exposure to systemic risk, two important risk dimensions for financial stability. We find that recognition versus disclosure of offsetable derivatives does not matter for default risk assessment, measured as CDS spreads, but matters for systemic risk assessment, measured as marginal expected shortfall. Additional analyses suggest that these results are explained by differential sophistication between CDS and equity investors. Our findings shed light on the unsettled debate about the divergent accounting treatment of offsetable derivatives under U.S. GAAP versus IFRS