Journal Article

Transparency, accounting discretion, and bank stability

Abstract: This article examines the consequences of accounting policy choices for individual banks? downside tail risk, for the codependence of such risk among banks, and for regulatory forbearance, or the decision by a regulator not to intervene. The author synthesizes recent research that provides robust empirical evidence for two effects of discretionary accounting policy choices by banks. First, these choices degrade transparency, an outcome that increases financing frictions, inhibits market discipline of bank risk taking, and allows regulatory forbearance. Second, they exacerbate capital adequacy concerns during economic downturns by compromising the ability of loan loss reserves to cover both unexpected recessionary loan losses and the buildup of unrecognized expected loss overhangs from previous periods. The article cautions that bank stability can be undermined by powerful interactions between low transparency and the capital adequacy concerns that stem from accounting discretion.

JEL Classification: E58; G32; G21; M41;

Bibliographic Information

Provider: Federal Reserve Bank of New York

Part of Series: Economic Policy Review

Publication Date: 2016

Issue: Aug

Pages: 129-149