The strategic under-reporting of bank risk

Begley, T A, Purnanandam, A and Zheng, K (2017) The strategic under-reporting of bank risk. Review of Financial Studies, 30 (10). pp. 3376-3415. ISSN 0893-9454

Abstract

We show that banks significantly under-report the risk in their trading book when they have lower equity capital. Specifically, a decrease in a bank’s equity capital results in substantially more violations of its self-reported risk levels in the following quarter. The under-reporting is especially high during the critical periods of high systemic risk and for banks with larger trading operations. We exploit a discontinuity in the expected benefit of under-reporting present in Basel regulations to provide further support for a causal link between capital-saving incentives and under-reporting. Overall, we show that banks’ self-reported risk measures become least informative precisely when they matter the most.