Author: Robert M. Bushman
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Economic Policy Review
Transparency, Accounting Discretion, and Bank Stability
August 2016 Volume 22, Number 1
JEL classification: E58, G21, G32, M41
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.
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