How Strict Accounting Rules Could Cause Bank Failures

In the years since the 2007–10 financial crisis, US lawmakers have tightened accounting rules governing what information banks must disclose and how they must present the data. The tighter rules make it harder for banks to paint a rosy but inaccurate picture of their financial health. Theoretically, that should lead to more-rational trading in the sector.

But research finds that strict disclosure requirements can lead to unnecessary bank failures. Without allowing banks discretion to modulate worrisome news, disclosure requirements can set off panic runs that cripple weak but solvent institutions, according to Chicago Booth’s Pingyang Gao and Duke University’s Xu Jiang. Banks that might have survived liquidity crises will instead fail.

Banks finance their long-term assets, such as loans, with short-term liabilities, such as deposits. This maturity mismatch between assets and liabilities makes them uniquely vulnerable to panic-driven runs even if there is no real crisis. Say depositors want to withdraw their assets, and a bank doesn’t have the cash on hand to immediately cover all the withdrawal requests. Hearing that the bank is short of cash, more depositors are likely to worry about the bank’s health and demand their money too, and the resulting run will cause the bank to fail.

This scenario hurts all involved, but banks can prevent it if they have some leeway in terms of what they disclose, and how, the researchers argue. For example, a bank can still, legally, estimate the borrowers’ default risk in a more aggressive fashion to reduce loan-loss-provision charges and present a rosier financial report. And while this leeway gives a bank the cover to misrepresent its financial health, it also gives the bank an important tool it can use to reassure investors.

Gao and Jiang find that such inflated reports reduce panic selling, and reduce the amount of investor selling even when fundamentals suggest the shares are overvalued. But regulation is a balancing act: “We show that reporting discretion reduces panic runs, but excessive reporting discretion weakens the market discipline,” write the researchers, who note that when one bank opportunistically massages its reports, it motivates other banks to do the same.