Prudential Regulation and Bank Accounting

This study focuses on how to design a mechanism that coordinates prudential regulation and bank accounting. I study a setting in which a bank chooses its loan quality and makes its asset substitution decision. The social planner sets the regulatory leverages for banks, and the accounting regime (either fair value accounting or historical cost accounting) for banks to report on loan performance. Using the ex ante bank value as the criterion, I find that the historical cost regime dominates the fair value regime for medium values of asset substitution risk; medium values of asset substitution constraint; low values of asset specificity; low values of fundamental risk of loans; high values of marginal benefit or low values of marginal cost of loan quality; and high values of the liquidity benefit of bank debtholders. Fair value accounting dominates for other values of these parameters. This study contributes to the theoretical literature on the debate about bank opacity by incorporating both the asset side and the liability side of bank's balance sheets in designing a mechanism to coordinate prudential regulation and bank accounting. The paper makes important policy implications on prudential regulation and bank accounting such as cycle-contingent regulations, asset risk class-contingent regulations and country-contingent accounting standard.