Banks’ Financial Reporting And Financial System Stability by Chicago Booth

Viral Acharya

Stern School of Business, New York University

Stephen G. Ryan

Stern School of Business, New York University

April 17, 2015

Prepared for the 50th Journal of Accounting Research Conference

Abstract

The use of accounting measures and disclosures in banks’ contracts and regulation suggests that the quality of banks’ financial reporting is central to the efficacy of market discipline and non-market mechanisms in limiting banks’ development of debt and risk overhangs in economic good times as well as mitigating the consequences of those overhangs with the potential to compromise the stability of the financial system in downturns. This essay examines how research on banks’ financial reporting, informed by the financial economics literature on banking, can generate insights about how to enhance the stability of the financial system. We begin with foundational discussion of how aspects of banks’ accounting for financial instruments, opacity, and disclosures may affect stability. We then develop a simple model of fair value and amortized cost accounting with regulatory forbearance that illustrates the complex interactions that can result among banks’ accounting treatments, investors’ willingness to fund banks’ assets, the incentives of banks and investors to gamble, and regulators’ policy of bailing out banks. We then evaluate representative papers in the existing empirical literature on banks’ financial reporting and stability, pointing out the research design issues that empirical accounting researchers (still) need to confront to develop well-specified tests able to generate reliably interpretable findings. We then provide examples of settings amenable to addressing these issues. We conclude with considerations for accounting standard setters and financial system policymakers.

Banks’ Financial Reporting And Financial System Stability – Introduction

The financial crisis has motivated an ongoing and many-faceted debate about the actions that policymakers can take to increase the stability of the financial system (“stability”). We define stability as the consistent ability for firms with positive net present value projects to obtain financing for those projects across the phases of the business or credit cycle (“cycle”). Two points are generally agreed upon in this debate. First, banks, the primary backstop providers of liquidity in the economy and issuers of federally guaranteed deposits to households, are critical to stability. Second, stability is enhanced by restraining banks’ undisciplined investment financed by readily available credit in booms and, through this and other means, reducing the frequency and severity of their disinvestment in busts due to restricted credit availability, excessive leverage (“debt overhangs”), or unwanted holdings of illiquid problem assets (“risk overhangs”). The debate pertains to the relative efficacy of alternative means by which to improve banks’ health and decision-making, individually and especially collectively, thereby promoting stability.

This essay examines the role that research on banks’ financial reporting, both accounting and disclosure, informed by the financial economics literature on banking can play in this debate. We identify researchable questions that this literature suggests accounting researchers should examine. We emphasize questions that address substantive debates among academics and policymakers, including the relative benefits and costs of: (1) transparency versus opacity about banks’ risk exposures; (2) the use of financial reporting versus regulatory reporting or dynamic capital requirements as mechanisms to build countercyclical buffers in banks’ regulatory capital; (3) alternative financial reporting measurements that differentially introduce volatility, anticipation of cycle turns, or discretion in banks’ reported income and regulatory capital; and (4) alternative financial reporting approaches that record financing on- rather than off-balance sheet or that present risk-concentrated exposures gross rather than net on the balance sheet. We explain research design issues that empirical accounting researchers must confront to develop well-specified tests of hypotheses bearing on these questions and thus to generate reliably interpretable findings. We also evaluate the limited success of the research to date in confronting these issues and the substantial opportunities that remain to do so. While researchers in accounting and finance are our primary intended audience, we hope that accounting standard setters and financial system policymakers will also find this essay useful.

Existing financial economics literature on banking regulation and crises stresses the perverse incentives of banks with debt and risk overhangs. Debt overhangs provide banks with incentives to remain under-capitalized, since the benefits of issuing equity primarily accrue to creditors, and to make investment decisions that effectively constitute gambles for resurrection (also called “risk shifting” or “asset substitution”), since their equity is an out-of-the-money call option that benefits strongly from volatility (Jensen and Meckling 1976; Dewatripont and Tirole 1993). Debt overhangs also provide banks with incentives to not make certain positive present value investments for which the benefits primarily accrue to creditors (Myers 1977; Admati et al. 2012). Risk overhangs limit banks’ willingness to make new positive present value investments in the types of asset involved in these overhangs (Gron and Winton 2001). Debt and risk overhangs that are highly positively correlated across banks especially strongly impair stability by limiting the opportunities for reintermediation within the banking sector and increasing the likelihood that banks receive taxpayer-funded bailouts when they fail en masse.

Banks' Financial Reporting

Banks' Financial Reporting

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