Regulatory discretion and banks' pursuit of "safety in similarity"

Abstract:

We propose that individual banks' reported loan losses and provisions for future loan losses are lower, all else equal (including their own financial statements), when the banking industry is weaker. We further hypothesize that this option of underreporting charge-offs and provisions provides banks with incentives, when the banking industry is weaker, to cluster more, or to seek "safety in similarity."

We provide evidence that large, individual U.S. banks indeed tend to report both lower charge-offs and lower provisions for loan losses, after controlling for their other determinants, when the banking industry is weaker. We also show that banks tend to be more clustered, or similar, when the industry is weaker. In addition, individual banks change their risk-taking to make it more similar to that of banking industry averages, and change it faster, when the industry is weaker. At the same time, in contrast to banks, we show that non-bank financial corporations show virtually no tendency to cluster more as their part of the financial sector weakens.

JEL classification: G28, G18

Keywords: Procyclicality, reporting discretion, bank capital, clustering, bank risk.