Discussion of Financial Accounting in the Banking Industry: A review of the empirical literature by Beatty and Liao 2013 JAE Conference Robert Bushman

Banking is not just another industry. Banks are special! Growth = f(Financial infrastructure, other determinants) Banking Sector Securities Markets Legal Regime/Property rights Political influence on markets Access to and fair pricing of capital Capital allocated to highest value uses: Across industry sectors Across firms Within firms Produce information ex ante about possible investments and allocate capital Monitor investments and exert corporate governance after providing finance Facilitate the trading, diversification, and management of risk Mobilize and pool savings Ease the exchange of goods and services

Bank balance sheets channel capital to the economy Output Allocation of capital to economy Delegated monitoring ex post and ex ante $Raw materials

Guiding investment decisions Channels through Which Corporate Transparency Affects Economic Performance Economic Performance Guiding investment decisions Corporate Governance Easing Financing Frictions Transparency Corporate reporting Information Intermediation Dissemination

Role of bank transparency transcends this framework. Micro-prudential regulation Macro-prudential regulation

Stability of Banks and Banking System Bank risk-taking can generate significant externalities Co-movement among banks can intensify negative shocks to economy Intervention decisions of bank regulators may be influenced by opacity

Structure of the Beatty & Liao Review Theory of Banks Choice of references is excellent. Bank accounting research Future research Valuation and risk relevance of bank accounting information Accounting discretion Effect of accounting methods on banks’ economic behaviors Really nice synthesis of 30 years of accounting research!

Building on Beatty and Liao Theory of Banks Bank accounting research Asymmetric information & financial stability Measuring bank opacity Accounting opacity & co-movement of banks: Co-movement in Illiquidity Co-movement in tail risk across banks Regulatory forbearance & troubled banks

Bank’s Financial Reporting Drivers of accounting opacity Bank’s Financial Reporting Creditors Equity investors Counterparties Accounting Rules Accounting Discretion Incentives of Bank Managers

Bank’s Financial Reporting Drivers of accounting opacity Bank’s Financial Reporting Accounting Discretion Accounting Rules Incentives of Bank Managers

Delayed Expected Loss Recognition (DELR) Known expected loan losses are not recognized in current provisions, but carried forward to future periods. overhang of unrecognized expected losses carry forward bank capital mingles unrecognized expected losses with economic capital Obscures true capital cushion Increases uncertainty about bank fundamentals Reported Capital

Bank’s Financial Reporting Accounting information and market discipline (Basel Pillar 3) Bank’s Financial Reporting Monitor and discipline bank risk-taking behavior Complement efforts of bank regulators Bank Managers

Does bank opacity weaken market discipline? Monitoring and risk discipline weakened DELR & Smoothing as measures of bank opacity Bank Managers

Captures intensity of disciplinary response Bushman & Williams: Accounting discretion, loan loss provisioning, and discipline of banks’ risk-taking (JAE 2012) Banks from 27 countries; In countries with regimes characterized by high levels of smoothing and DELR: Disciplinary pressure on bank risk-taking is dampened; Consistent with diminished transparency inhibiting outside monitoring. Market Discipline => Outside forces discipline banks to increase capital in response to increased risk. Captures intensity of disciplinary response to risk increase Bank Capital = 0 + 1*Volatility 1 decreasing in DELR and Smoothing

Bank opacity and correlated accounting strategies LLP Smoothing Delayed Expected Loan Loss Recognition (DELR) A number of other potential dimensions for accounting discretion: Fair value accounting for level 2 & 3 assets Securitization Realized gains and losses on AFS Deferred Tax Assets Window dressing (repos and short-term borrowings) Research question: To what extent is LLP management correlated with discretion along other dimensions? Huizinga and Laeven (2012) show that during crisis, banks that delayed writing down private-label MBS also appear to manage LLP downwards.

Time varying competitive pressure and incentives to exploit discretion Loss provisioning / Voluntary disclosure Non-Discretionary Discretion Competitive Pressure Emerging literature uses textual analysis and inter-state banking deregulation to examine how bank competition impacts LLP discretion and voluntary disclosure. Burks, Cuny, Gerakos and Granja (2013) Dou, Ryan, and Zou (2013) Bushman, Hendricks & Williams (2013)

Banks’ balance sheets channel capital to the economy Output: Allocation of capital to economy Delegated monitoring $Raw materials

The banking sector as a transmission mechanism Economic shock

Co-movement among banks transmits shocks to the economy Can accounting opacity influence shock transmission? Shock transmission B/S Shrinkage Co-movement Economic shock

Financing frictions are at the heart of many theories of monetary transmission and capital crunches Bank capital stands between a bank & destruction during economic turmoil. Capital impaired during downturn Financing frictions inhibit capital replenishment Good times Severe balance sheet contraction Decreased probability of bank survival Weakened competitive position and market share Increased borrowing costs and decreased availability of credit

Does bank opacity create co-movement in illiquidity among banks? Many banks become illiquid simultaneously Opacity increases uncertainty over bank fundamentals

Bushman & Williams (2013): Delayed Expected Loss Recognition & The Risk Profile of Banks Liquidity providers less willing to provide liquidity in stocks with greater uncertainty about fundamental value Liquidity drops for high-uncertainty stocks as a group when macro-uncertainty increases Liquidity of low transparency banks co-move, with effect greater during times of crisis Brunnermeier & Pedersen, 2009, Grossman & Miller, 1988, Lang & Maffett, 2011 Consistent with DELR reducing transparency & increasing uncertainty over fundamentals: Liquidity of high DELR banks decreases relatively more during downturns. Liquidity of high DELR banks co-moves relatively more with other banks, especially during economic downturns. => High DELR banks become simultaneously illiquid during downturns!

Does bank opacity create co-movement in tail risk? Simultaneous increase in probability of steep drop in equity value or severe balance contraction.

Macro Conditioning Variables Estimating tail risk (VaR) of distribution over equity values or market value of assets Tail risk: Estimate conditional 1% quantile of equity returns for each bank % change in equity value of bank or bank system Macro Conditioning Variables Examine how tail risk of individual banks change during downturns for high vs. low DELR banks Examine how tail risk of aggregate banking sector changes during downturns conditional on distress of individual (high vs. low DELR) banks. Rt Mt

Bushman & Williams, 2013 Delayed Expected Loss Recognition & The Risk Profile of Banks During recessions: Higher DELR banks have higher risk of severe drop in equity value; Distress at High DELR banks => significant increase in tail risk of severe drop in equity value of the banking system. When many banks simultaneously delay expected loss recognition in good times group members simultaneously face consequences of opacity, loss overhangs and financing frictions during downturns. DELR acts like a systematic risk factor where DELR banks as a “herd” are negatively impacted and transmit pain to the economy.

Bank opacity and regulatory forbearance (decision not to close troubled banks) direct access Banking literature posits incentives for bank regulators to practice forbearance; Difficult to forbear if bank is transparent and outsiders know that bank is in trouble; Do regulators exploit opacity to forbear on intervening in troubled banks? Incentives of Bank Regulators

Does bank opacity increase bank regulators' ability to forbear from intervening in troubled banks? direct access Gallemore (2017) exploits bank closures during recent crisis, finding that: Bank opacity (DELR) is positively associated with forbearance during crisis. Bank Regulators