Haresh Sapra

Should Banks' Stress Test Results Be Disclosed? An Analysis of the Costs and Benefits

Stress tests have become an important component of the supervisory toolkit. However, the extent of disclosure of stress-test results remains controversial. We argue that while stress tests uncover unique information to outsiders — because banks operate in second--best environments with multiple imperfections — there are potential endogenous costs associated with such disclosure.

Fair Value Accounting and Financial Stability

Market prices give timely signals that can aid decision making. However, in the presence of distorted incentives and illiquid markets, there are other less benign effects that inject artificial volatility to prices that distorts real decisions. In a world of marking-to-market, asset price changes show up immediately on the balance sheets of financial intermediaries and elicit responses from them. Banks and other intermediaries have always responded to changes in economic environment, but marking-to-market sharpens and synchronises their responses, adding impetus to the feedback effects in financial markets. For junior assets trading in liquid markets (such as traded stocks), marking-to-market is superior to historical cost in terms of the trade offs. But for senior, long-lived and illiquid assets and liabilities (such as bank loans and insurance liabilities), the harm caused by distortions can outweigh the benefits. We review the competing effects and weigh the arguments.

A Real Effects Perspective to Accounting Measurement and Disclosure: Implications and Insights for Future Research

Accounting measurement and disclosure rules have a significant impact on the real decisions that firms make. In this essay, we provide an analytical framework to illustrate how such real effects arise. Using this framework, we examine three specific measurement issues that remain controversial: (1) How does the measurement of investments affect a firms investment efficiency? (2) How does the measurement and disclosure of a firms derivative transactions affect a firms choice of intrinsic risk exposures, risk management strategy, and the incentive to speculate? (3) How could marking-to-market the asset portfolios of financial institutions generate procyclical real effects? We draw upon these real effects studies to generate sharper and novel insights that we believe are useful not only for the development of accounting standards, but also for guiding future empirical research.

The Economic Trade-Offs in the Fair Value Debate

In this paper, I provide two general insights that are useful in evaluating the economic trade-offs of alternative accounting measurement rules. First, when there are multiple imperfections in the world, restricting a strict subset of it need not always improve welfare. Second, a firm is not a black box that operates independently of the measurement environment. Measuring a firm’s operations affects the firm’s actions which, in turn, affect the underlying distribution of cash flows that is being measured. Using these two insights, I discuss the economic consequences of accounting measurement rules that strive for greater transparency. In particular, I focus on the costs and benefits of fair value accounting and its implications for financial stability.

Market Pressure, Control Rights, and Innovation

There has been significant controversy over the desirability of anti-takeover protection devices, such as poison pills and golden parachutes. These devices are usually viewed negatively because they are associated with entrenchment and insider rent extraction. This position, however, is subject to debate. Insider protection, for instance, has the advantage of transferring control to better-informed insiders. In fact, in this paper we show that insider protection can arise endogenously as an optimal contracting device. Our main result is that the optimality of insider protection depends crucially on the degree of innovation of the firms activities, with insider protection being desirable only under significant innovation. For highly innovative projects, in particular, a takeover bid can be optimally rejected even when it offers a significant premium over the market price of the firm.

Agency Conflicts, Bank Capital Regulation and Accounting Measurement

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.