Prudential Regulation and Bank Accounting

Abstract

This study focuses on how to design a mechanism to coordinate prudential regulation with bank accounting. I study a setting in which a bank chooses loan quality and makes asset substitution decisions. The social planner sets regulatory leverages and the accounting regime (either fair value accounting or historical cost accounting) for banks to report on loan performance. By the standard of ex ante bank value, I nd that the historical cost regime dominates the fair value regime for medium values of asset substitution risk and asset substitution constraint, for low values of asset specicity, fundamental risk of loans and marginal cost of loan quality, and for high values of marginal benet of loan quality and the liquidity benet of bank debtholders. For other values of these parameters, fair value accounting dominates. This study contributes to the theoretical debate on bank opacity by incorporating both the asset side and the liability side of the balance sheet in designing a mechanism to coordinate prudential regulation with bank accounting. The paper makes important policy implications such as cycle-contingent regulations, asset risk class-contingent regulations and country-contingent accounting standards.