Fed in Print

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 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
M41 - Business Administration and Business Economics; Marketing; Accounting; Personnel Economics - - Accounting - - - Accounting

Fed-in-Print is the central catalog of publications within the Federal Reserve System. It is managed and hosted by the Economic Research Division, Federal Reserve Bank of St. Louis.

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