Regulation, Supervision and Accounting Conservatism: The Interaction of the Three Pillars of Basel II on the Quality of Reported Earnings in Worldwide Banks

Abstract

Accounting conservatism is a quality of earnings positively associated with the strength of banking regulation and supervision and also high market discipline, but there still remains the unresolved question of the way these three pillars of Basel II interact with each other. We analyse how regulatory and supervisory regimes in the banking industry clearly interact with market discipline measures, such as listing status, ownership, market concentration and disclosure requirements between ten years before Basel II fails, drawing upon data from 14,651 bank year observations from 54 different countries. According to our findings, there is a clear correlation between the strength of the enforcement of regulation and supervision and accounting conservatism success in countries where market discipline fails. That is to say, the supervisory power reinforces the effect of listing status, ownership and concentration on conservatism whereas the capital regulatory system mitigates the effect of market discipline on conservatism. We also evidence that in a powerful regulatory system, more disclosure requirements are associated in less conservatism policies in financial entities. Strong increases in regulation, its enforcement and supervisory power introduced in the Basel III mechanism is subject to the debate posed in this paper. The quality of accounting earnings can be improved to prevent bank failures through the application of strong Pillars I and II, i.e., regulation and supervision. Having said that, market discipline still remains a key factor in achieving financial stability.

Keywords

• Accounting conservatism
• Bank regulation
• Bank supervision
• Loan loss recognition
• Market discipline