Depositors’ discipline, banks’ accounting discretion, and depositors’ expectations of implicit government guarantees

In this study, we examine the depositors’ tendency to apply financial discipline to banks that adopt discretionary accounting practices. We use estimates of discretionary loan loss provisions (DLLP)—the difference between an observed provision and a model-determined, notionally correct provision—to quantify the extent to which banks are engaging in discretionary accounting practices. We examine whether depositors perceive that discretionary accounting practices increase credit risk and punish such practices by withdrawing deposits or requiring higher interest rates. We also examine whether depositors’ expectations of implicit government guarantee moderate this relationship by comparing the differences in depositors’ responses depending on whether a bank is large or small. Using US commercial bank data from 2001Q1 to 2010Q4, we find that uninsured deposit growth is negatively associated with banks’ DLLP. The findings suggest that depositors punish banks’ discretionary accounting practices. We also find that within the non-too-big-to-fail (non-TBTF) banks, depositors react sensitively to DLLP practices during both the crisis and non-crisis periods. However, for those too-big-to-fail (TBTF) banks, depositors react sensitively to DLLP practices only during the non-crisis period, but not during the crisis period. In addition, we find that banks subject to US government bailout actions during the 2008–2009 crisis period received less depositor discipline than other banks. In general, our findings suggest that the uninsured depositors’ discipline did exist during the pre-crisis period. Depositors punish banks for their behavior in increasing the information asymmetry between the banks and outsider creditors. However, policies such as rescuing big banks or increasing the deposit insurance coverage may reduce such market discipline.