Accounting Values versus Market Values and Earnings Management in Banks

Banks worldwide are subject to increasing regulation and, simultaneously, find themselves under the close scrutiny of market analysts and the screening of large institutional investors. Banks are required to maintain minimal equity relative to both total and risky assets. Market analysts expect banks to grow at a certain rate and to show reasonable returns on assets and on equity. The question arises as to what extent capital adequacy regulations, on the one hand, and expectations concerning banks' profits, on the other, create incentives for banks to hide earnings in good times (by understating equity) and increase reported earnings in bad times. We develop a model, mapping the optimal behavior of a bank that operates in an uncertain environment and attempts to maintain capital requirements and to meet target growth rates while building a reservoir of hidden earnings for capitalization in future bad periods.