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

2. 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

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

4. 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

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

6. 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

7. 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!

8. 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

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

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

11. 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

12. 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

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

14. 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

15. 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.

16. 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)

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

18. The banking sector as a transmission mechanism
Economic shock

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

20. 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

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

22. 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!

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

24. 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

25. 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.

26. 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

27. 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