The Theory of Financial Stability Meets Reality

A large literature at the intersection of economics and finance offers prescriptions for regulating banks to increase financial stability. This literature abstracts from the discretion that accounting standards give banks over financial reporting, creating a gap between the information assumed to be available to regulators in models of optimal regulation and the information available to regulators in reality. We bridge insights from the economics, finance, and accounting literatures to synthesize knowledge about the design and implementation of bank regulation and identify areas where more work is needed. We present a simple framework for organizing the relevant ideas, namely the externalities that motivate bank regulation, the rationales for allowing accounting discretion, and the use of discretion to circumvent regulation. Our takeaway from reviewing work in these areas is that academic studies of bank regulation and accounting discretion require a more unified approach to design optimal policy for the real world.