Bank Stress Tests and Accounting Discretion

• In Event: Financial Accounting and Reporting

Abstract

We examine stress tests through the lenses of an implicit, underlying incentives mechanism for
bank managers to exercise accounting discretion. Our research aim and the relevant components
are examined in defined steps by reference to Propensity Score Matching analysis, which is
paired with a Difference-in-Difference approach, and a fixed effects regression model. Our
findings show that larger banks with an asset portfolio of relatively low quality, reduced
profitability, and higher exposure to market-based activities are more likely to be stress tested.
Stress tests exacerbate the effort of tested banks to recapitalise their balance sheet and improve
their risk profiles. However, they do not significantly affect the key tools that bank managers
use to apply accounting discretion. In this vein, tested banks are highly engaged in accounting
discretion over loan loss provisions to manage both income and capital figures. Banks with low
capital adequacy are found to apply discretionary practices to a greater extent. Moreover, the
banks that participated in early stress tests appear to engage in accounting discretion to a higher
degree compared to those participated in some later exercise, which reveals an upward
movement on the regulatory learning curve. Our results also show that stricter regulatory rules,
more robust supervisory regimes, and more transparent economies mitigate the impact that
stress tests have on the incentives of the managers of tested banks to exercise accounting
discretion even though the relevant incentives cannot be eliminated.

Authors

• Dimitrios Gounopoulos, University of Bath

• Nikolaos Papanikolaou, Newcastle University

• Constantine Zopounidis, Technical University of Crete