Banks' Asset Reporting Frequency and Capital Regulation: An Analysis of Discretionary Use of Fair-Value Accounting

Abstract

This paper examines banks' choice between fair-value and historical-cost accounting when reported accounting information is used in capital requirement regulation. We center our analysis on a key difference between fair-value and historical-cost accounting: the frequency with which asset value changes are reported. We show that the elasticity of banks' loan returns to aggregate lending is a critical determinant of the interaction between capital adequacy requirements and accounting choices. If lending returns are inelastic, then higher capital requirements reduce fair-value usage. By contrast, higher capital requirements encourage fair value if capital requirements are low and lending returns are sufficiently elastic. In equilibrium, banks may elect different accounting choices, and we find that mandating uniform adoption of historical cost (fair value) is desirable when capital requirements are loose (tight). Our study offers many other implications about fundamental links between accounting and prudential choices.

Do Delays in Banks' Loan Loss Provisioning Affect Economic Downturns? Evidence from the U.S. Housing Market

“…The Great Recession sparked discussion of banks' financial reporting in general and their loan loss recognition in particular Leuz, 2009, 2010;Barth and Landsman, 2010;Vyas, 2011;Liao, 2011, 2014;Williams, 2012, 2015;Huizinga and Laeven, 2012;Kothari and Lester, 2012;Acharya and Ryan, 2016;Bischof et al, 2018;Corona et al, 2018).…”

Prudential Regulation and Bank Accounting

“…13 13 Under historical cost accounting, X is not disclosed, so the social planner cannot precisely induce the socially desirable choice of asset substitution, but rather an optimal incidence of asset substitution. In this regard, regulation is less ecient than second-best regulation under fair value accounting.…”

Interplay between Accounting and Prudential Regulation

“…Heaton, Lucas and McDonald (2010) analyze the interaction between mark-to-market accounting and capital requirements in affecting the social cost of regulation. Corona, Nan and Zhang (2019a) examine the discretionary use of fair value accounting and its impact on bank lending. Lu, Sapra and Subramanian (2019) study the optimal use of mark-to-market accounting in implementing capital requirements, in the presence of asymmetric information and agency conflicts.…”

“…Our paper is also related to the burgeoning theoretical literature that examines the role of accounting measurements and disclosure in affecting financial stability and prudential regulation, see Goldstein and Sapra (2014) for a recent survey. Corona, Nan and Zhang (2019b) examine the coordination role of stress-test disclosure in affecting bank risk-taking. Gao and Jiang (2018), Liang andZhang (2019), andZhang (2020) analyze the role of accounting information in stabilizing bank runs.…”

“…Gao and Jiang (2018), Liang andZhang (2019), andZhang (2020) analyze the role of accounting information in stabilizing bank runs. Corona, Nan and Zhang (2015) examine the impact of accounting information quality on the efficiency of capital requirements and banks' risk-taking incentives, taking into account the competition among banks. In this paper, we solve for the optimal information system and we shed light on how regulatory capital should be tailored to the accounting standards.…”