The recent financial crisis has energized politicians and regulators to scrutinize financial accounting standards as never before, creating significant pressure for change. For example, recent high profile proposals by Financial Stability Forum (2009) and U.S. Treasury (2009) call for standards setters to re-evaluate the incurred loss model underlying current loan loss provisioning requirements and consider a range of alternative approaches. A premise of these proposals is that loan loss accounting should adopt a more forward looking orientation that allows for recognition of future expected loan losses earlier in the credit cycle, which in turn would dampen pro-cyclical forces in periods of financial crisis. A key aspect of these alternatives is that, relative to the incurred loss model, they would generally increase the scope for judgment and discretion in determining loan loss provisions. However, as has long been recognized (e.g., Watts and Zimmerman (1986)), accounting discretion is a double-edged sword. On the one hand, increased discretion can facilitate incorporation of more information about future expected losses into loan provisioning decisions, but on the other hand it increases potential for opportunistic accounting behavior by bank managers, which may degrade the transparency of banks and lead to negative consequences.

The main objective of this paper is to empirically delineate significant economic consequences associated with observable differences in discretion permitted to banks under existing regulatory regimes. Exploiting significant cross-country variation in observed loan provisioning practices, we generate country-level measures of the discretion allowed to banks’ within a given country, where discretion is estimated relative to an incurred loss model. Using these country-level measures of observed discretion, we perform three fundamental analyses geared towards isolating implications of discretion for both the information properties of loan provisions and for bank transparency. First, we investigate the extent to which banks in countries allowing higher discretion use this enhanced flexibility to infuse loan provisioning practices with a more forward looking orientation relative to banks in lower discretion countries. Next, we investigate the possibility that discretion imposes costs on the banking system by impeding the ability of regulators and outside investors to monitor and discipline bank risk taking. We capture the extent of discipline over bank risk taking using two measures. First, we study the relation between discretion and the sensitivity of changes in bank capital to changes in the riskiness of a bank’s assets. Secondly, we examine the relation between discretion and the observed risk-shifting behavior of banks.