Banks’ Financial Reporting and Financial System Stability

• Published date: 01 May 2016
• Author: STEPHEN G. RYAN,VIRAL V. ACHARYA
• DOI: http://doi.org/10.1111/1475-679X.12114
• Date: 01 May 2016

DOI: 10.1111/1475-679X.12114

Journal of Accounting Research

Vol. 54 No. 2 May 2016

Printed in U.S.A.

Banks’ Financial Reporting and

Financial System Stability

VIRAL V. ACHARYA

∗AND STEPHEN G. RYAN

∗

ABSTRACT

The use of accounting measures and disclosures in banks’ contracts and reg-

ulation suggests that the quality of banks’ financial reporting is central to the

efficacy of market discipline and nonmarket mechanisms in limiting banks’

development of debt and risk overhangs in economic good times and in mit-

igating the adverse consequences of those overhangs for the stability of the

financial system in downturns. This essay examines how research on banks’

financial reporting, informed by the financial economics literature on bank-

ing, can generate insights about how to enhance the stability of the financial

system. We begin with a foundational discussion of how aspects of banks’ ac-

counting and disclosures may affect stability. Wethen evaluate representative

papers in the empirical literature on banks’ financial reporting and stability,

pointing out the research design issues that empirical accounting researchers

need to confront to develop well-specified tests able to generate reliably in-

terpretable findings. To this end, we provide examples of settings amenable

to addressing these issues. We conclude with considerations for accounting

standard setters and financial system policy makers.

JEL codes: G01; G21; G28; M41; M48

Keywords: banks; financial reporting; financial system; stability; opacity;

provision for loan losses; fair value accounting; amortized cost accounting

∗New York University.

Accepted by Christian Leuz. We thank Jessica Keeley and Saptarshi Mukherjee for excel-

lent research assistantship. We also thank Gauri Bhat, Pingyang Gao, Haresh Sapra, Dushyant

Vyas, Xi Wu, Chenqi Zhu, and the participants of the 2015 (50th annual) Journal of Accounting

Research Conference for useful comments.

277

Copyright C, University of Chicago on behalf of the Accounting Research Center,2016

278 V.V.ACHARYA AND S.G.RYAN

1. Introduction

The financial crisis has motivated an ongoing and many-faceted debate

about the actions that policy makers 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, as the pri-

mary backstop providers of liquidity in the economy and issuers of feder-

ally guaranteed deposits to households, are critical to stability. Second, sta-

bility is enhanced by restraining banks’ undisciplined investment financed

by readily available credit in economic good times and thereby reducing

the frequency and severity of their disinvestment due to restricted credit

availability in downturns. In particular, deterring banks from accumulat-

ing excessive leverage (debt overhangs) and holdings of potentially illiquid

assets (risk overhangs) during good times is crucial to mitigating their dis-

investment in downturns. 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

(i.e., accounting and mandatory disclosure) can play in the debate about

how policy makers can increase stability. Our focus on stability distinguishes

this essay from recent surveys of the broad literature on banks’ financial re-

porting (Ryan [2011], Beatty and Liao [2014]). Informed by the extensive

financial economics–based literature on banking, we identify researchable

questions that accounting researchers should examine. We emphasize ques-

tions that address substantive debates among academics and policy makers,

including the relative benefits and costs of (1) transparency versus opacity

about banks’ risk exposures; (2) the use of financial reporting versus reg-

ulatory reporting or dynamic capital requirements as mechanisms to build

countercyclical buffers in banks’ regulatory capital; (3) alternative account-

ing measurement bases that differentially introduce volatility, anticipation

of cycle turns, or discretion in banks’ reported income and regulatory cap-

ital; and (4) alternative accounting approaches that record financing on-

rather than off-balance sheet or 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 and im-

plement well-specified tests of hypotheses that are capable of generating

reliably interpretable findings regarding these questions. 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 policy makers will also find

this essay useful.

Existing financial economics literature on bank regulation and financial

crises stresses the perverse incentives of banks with debt and risk overhangs.

BANKS’FINANCIAL REPORTING AND FINANCIAL SYSTEM STABILITY 279

Debt overhangs provide banks with incentives to remain undercapitalized,

since the benefits of issuing equity primarily accrue to creditors, and to

make investment decisions that effectively constitute gambles for resur-

rection (also called “risk shifting” or “asset substitution”), since their eq-

uity is an out-of-the-money call option that benefits strongly from volatility

(Jensen and Meckling [1976], Dewatripont and Tirole [1993]). Debt over-

hangs also provide banks with disincentives to invest in positive present

value projects 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 assets involved

in these overhangs (Gron and Winton [2001]). Debt and risk overhangs

that are highly positively correlated across banks impair stability by limiting

the opportunities for reintermediation within the banking sector and by

increasing the likelihood that banks receive taxpayer-funded bailouts when

they fail en masse.

These perverse incentives can manifest in various ways depending on the

extent of banks’ debt overhangs, the nature of the problem assets involved

in banks’ risk overhangs, and other contextual factors. Examples include

banks avoiding recording provisions for loan losses by rolling over non-

performing loans (as occurred with U.S. banks’ lending to less-developed

countries in the 1980s and with Japanese banks’ lending to zombie borrow-

ers in their prolonged banking crisis beginning in the early 1990s) or dou-

bling up bets on illiquid securities that have experienced significant adverse

price shocks (as occurred with U.S. thrifts’ accumulation of junk bonds and

other risky assets in the deregulatory period in the 1980s prior to the thrift

crisis). Banks are especially likely to engage in such behaviors if they ra-

tionally expect central banks to step in as lenders of last resort (LOLRs)

by providing liquidity against pledged problem assets. Such interventions

increase the market value of the assets without addressing the underlying

reasons why they became problem and might even lead banks to increase

their exposure to risky assets ex ante. In addition to making banks fragile,

gambles for resurrection reduce banks’ aggregate provision of liquidity to

deserving sectors of the economy and lead to decreases in asset prices when

banks fail or the gambles are otherwise unwound. Decreases in the prices of

widely held illiquid assets make banks collectively fragile. Limiting banks’

development of debt and risk overhangs ex ante and their ability to gamble

for resurrection ex post is thus critical to ensuring stability.

A key assumption in this literature is that banks’ leverage and risk are

not perfectly observable (e.g., Diamond and Dybvig [1983]). Imperfect ob-

servability occurs for various reasons. For example, it is difficult to measure

the value and risk of banks’ exposures when the relevant markets are illiq-

uid. Many of these exposures are cycle-contingent (e.g., loan commitments,

credit and liquidity support in securitizations, and margin calls on deriva-

tives). While imperfect observability implies that market discipline, private

contracts, and bank regulation cannot ensure that banks maintain optimal

risk levels, banks’ contracts and regulation still regularly employ accounting