In our paper, Accounting Discretion, Loan Loss Provisioning and Discipline of Banks’ Risk-Taking, forthcoming in the Journal of Accounting and Economics, we empirically delineate economic consequences associated with differences in accounting discretion permitted to banks under existing regulatory regimes. Policy makers argue that loan loss accounting should allow bank managers’ more discretion to incorporate forward-looking judgments into loan loss provisions. This paper explores potential consequences of such increased discretion for the role of accounting information in supporting outside discipline of bank risk-taking.

Using a large sample of banks from 27 countries, we estimate two distinct constructs of the extent to which discretionary loan provisioning practices within a country reflect a forward-looking orientation. We investigate whether each aspect is associated with stronger or weaker discipline of bank risk-taking. We model risk-taking discipline using two measures: (1) the sensitivity of changes in bank capital to changes in bank risk; and (2) the observed risk-shifting behavior of banks. We find that discretionary provisioning in the form of earnings smoothing dampens disciplinary pressure on risk-taking, consistent with smoothing reducing bank transparency and inhibiting monitoring by outsiders. In contrast, discretionary provisioning practices that increase the extent to which current loan provisions explicitly anticipate future loan portfolio deterioration are associated with enhanced discipline of bank risk-taking.

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