We show that banks significantly under-report the risk in their trading book when they have lower equity capital. Specifically, a decrease in a bank's equity capital results in substantially more violations of its self-reported risk levels in the following quarter. The under-reporting is especially high during the critical periods of high systemic risk and for banks with larger trading operations. We exploit a discontinuity in the expected benefit of under-reporting present in Basel regulations to provide further support for a causal link between capital-saving incentives and under-reporting. Overall, we show that banks' self-reported risk measures become least informative precisely when they matter the most.

Using a representative sample of Residential Mortgage-Backed Securities (RMBS), we show that deal sponsors use the equity tranche as a signal of the unobserved quality of opaque pools. Deals with higher level of equity tranche have significantly lower foreclosure rates that cannot be explained away by observable credit risk or correlation structure of the loans in the underlying pool. Further, we analyze trade-offs that are unique to bundling and tranching of loans in securitization deals as compared to the sale of a single asset. Consistent with DeMarzo's (2005) model, we show that the extent of AAA-rated tranche is significantly higher for pools that bundle loans with commonality in their private information but with uncorrelated risks. Overall, we uncover some of the key economic drivers of RMBS design and document contracting frictions that the design was able to mitigate even during the peak of the subprime mortgage market.

Credit rating agencies emphasize the importance of specific financial ratio thresholds in their rating process. Firms on the favorable side of these thresholds are more likely to receive higher ratings than similar firms that are not. I show that firms near these salient thresholds respond to the incentive to improve their appearance on this dimension by distorting real investment activities during periods leading up to bond issuance. These firms are significantly more likely to reduce R&D and SG&A expenditures compared to observationally similar firms not near a threshold. Subsequently, they are more likely to experience declines in innovation output, profitability, and Tobin's Q. These distortions highlight an important cost of arms-length financing and an adverse consequence of transparency in credit rating criteria.

We show that banks significantly under-report the risk in their trading book when they have lower equity capital. Specifically, a decrease in a bank's equity capital results in substantially more violations of its self-reported risk levels in the following quarter. The under-reporting is especially high during the critical periods of high systemic risk and for banks with larger trading operations. We exploit a discontinuity in the expected benefit of under-reporting present in Basel regulations to provide further support for a causal link between capital-saving incentives and under-reporting. Overall, we show that banks' self-reported risk measures become least informative precisely when they matter the most.

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