Do the Effects of Accounting Requirements on Banks’ Regulatory Capital Adequacy Undermine Financial Stability?

Abstract

During the 2007–2009 financial crisis, many parties criticized aspects of accounting requirements for banks as undermining financial stability. These criticisms generally reflect the view that these requirements primarily affect stability through their effects on banks’ regulatory capital adequacy. I critically evaluate whether this idea can be sustained on logical and evidential grounds. I explain how accounting requirements typically have quite small effects on banks’ regulatory capital adequacy. I discuss the plausibility of the alternative view that accounting requirements primarily affect stability by improving banks’ understanding of their risks and their transparency to markets and regulators. Because securitization is the setting in which banks’ regulatory capital adequacy is most likely to be significantly affected by accounting requirements, I describe empirical research on significant changes in securitization accounting effective in 2010. I explain how even in this setting regulatory capital adequacy incompletely explains how accounting requirements for banks affect stability.