Accounting for Banks, Capital Regulation and Risk-Taking

This paper examines risk-taking incentives in banks under different accounting regimes with capital regulation. In the model the bank’s decisions of capital issuance and investment policy are jointly determined. Given exogenous minimum capital requirement, the bank is more likely to issue equity capital in excess of the minimum required level and implement less risky investment policy under either lower-of-cost-ormarket accounting or fair value accounting than under historical cost accounting. But fair value accounting may induce more risk-taking compared to lower-of-cost-or-market accounting due to short term interest in the part of the bank. However, the disciplining role of lower-of-cost-or-market accounting may discourage bank’s incentive to exert project discovery effort ex-ante if the ex-ante effort plays an important role. From the regulator’s perspective, the optimal accounting choice will be governed by a tradeoff between the social cost of capital regulation and the efficiency of the bank’s project discovery efforts. When the former effect dominates, the regulator prefers lower-ofcost-or-market accounting; when the later effect dominates, the regulator may prefer other regimes. ∗This paper is based on the second part of my dissertation at Columbia University. I am especially grateful for the support and guidance from my advisor Tim Baldenius. I have also benefited a lot from members of my dissertation committee: Patrick Bolton, Hui Chen, Bjorn Jorgensen, and Nahum Melumad. I would also like to thank Jon Glover, Thomas Hemmer (2009 AAA session discussant), Pierre Liang, Xiaojing Meng, Gil Sadka and seminar participants at Columbia University for their helpful comments and suggestions. Any errors are my own. †Contact: Tepper School of Business, Carnegie Mellon University, 5000 Forbes Avenue, Pittsburgh, PA, 15213. Email: [email protected]