Discretionary Accounting and the Behavior of Japanese Banks Under Financial Duress

Abstract

This paper investigates utilization of discretionary accounting practices in the context of international bank regulation under the Basle Accord. Specifically, we explore implications of earnings management as a means of regulatory-capital arbitrage by Japanese banks during a period of financial duress, 1989-1996. Using a sample of 607 pooled time series and cross-sectional observations, we find evidence that Japanese banks’ lending was capital constrained, and that banks set gains on securities sales and loan-loss provisions in such a way as to smooth reported income and replenish regulatory capital. Our results support the hypothesis that the form of earnings management examined may have been instrumental in enabling some Japanese banks to comply with international capital regulation. We contend that this behavior is otherwise inexplicable on the basis of significant informational, tax or economic motivations.

Keywords: Regulatory-capital arbitrage, Accounting discretion, Capital regulation, Basle accord

JEL Classification: F34, F42, G28