The Benefits of Decoupling Financial Reporting from Bank Capital Regulation

Abstract

This paper examines the linkage between financial reporting and bank capital regulation. Some recent studies focus on the impact of fair value accounting on regulatory capital and do not find that it has played a significant role in this financial crisis. However, this paper documents that if the effects of financial reporting on regulatory capital ratios for the three largest U.S. banks are examined while holding other factors constant, fair value accounting has contributed significantly to the deterioration of bank capital adequacy. And its effects were much larger than those of the provision for loan losses in the early stage of this crisis for two banks. In addition, the pro-cyclical impact of accounting on capital regulation was obvious for all three banks. However, decoupling financial reporting from regulatory capital may eliminate such impact and establish an important stabilizer for bank capital regulation if the associated asymmetric risks can be contained.

Keywords: Financial reporting, Banks, Financial crisis, Tier 1 capital, Leverage ratio, Tier 1 capital ratio, Fair value accounting, Historical cost accounting, Bank capital regulation, Pro-cyclicality

JEL Classification: G18, G21, G30, K22, M41, M48