Agency Conflicts, Bank Capital Regulation and Accounting Measurement

36 Pages Posted: 16 Dec 2016

See all articles by Tong Lu

Tong Lu

University of Houston

Haresh Sapra

Booth School of Business, University of Chicago

Ajay Subramanian

Georgia State University

Date Written: December 15, 2016

Abstract

We develop a model to show how shareholder-creditor agency conflicts interact with accounting measurement rules to influence the design of bank capital regulation. Relative to a benchmark autarkic regime, higher capital requirements mitigate inefficient asset substitution, but exacerbate underinvestment due to debt overhang. The optimal regulatory policy balances the distortions created by underinvestment and asset substitution, while also incorporating the excess cost of equity relative to debt financing for banks. The optimal regulatory policy can be implemented using historical cost accounting for low values of the excess cost of equity. For intermediate levels of the excess cost of equity, fair value accounting is necessary for regulation to optimally respond to interim performance signals by imposing higher capital requirements that mitigate asset substitution. If the excess cost of equity is sufficiently high, however, the optimal regulatory policy features forbearance by permitting asset substitution to mitigate underinvestment. Overall, our results highlight the importance of accounting measurement in influencing the design of bank regulation through the implementation of capital requirements.

Keywords: Accounting Measurement, Bank Capital Regulation, Agency Conflicts

JEL Classification: G21, G28, G32, M41, M48

Suggested Citation

Lu, Tong and Sapra, Haresh and Subramanian, Ajay, Agency Conflicts, Bank Capital Regulation and Accounting Measurement (December 15, 2016). Available at SSRN: https://ssrn.com/abstract=2885895 or http://dx.doi.org/10.2139/ssrn.2885895

Tong Lu

University of Houston ( email )

Houston, TX 77204
United States

Haresh Sapra

Booth School of Business, University of Chicago ( email )

5807 S. Woodlawn Avenue
Chicago, IL 60637
United States

Ajay Subramanian (Contact Author)

Georgia State University ( email )

Depts. of Finance & Risk Management and Insurance
P.O. Box 4050
Atlanta, GA 30303
United States
404-413-7483 (Phone)

HOME PAGE: http://robinson.gsu.edu/profile/ajay-subramanian/

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