Information Asymmetry and Discretionary Accounting in European Banks

Abstract

Recent theoretical research suggests that information risk is a non-diversifiable risk factor and should therefore affect the cost of capital of the individual firm. This study investigates this notion for listed European banks during the period 2005-2015. I use two measures based on the level and uncertainty of discretionary accounting choices to proxy information risk and investigate the effect on the information asymmetry component of banks' cost of capital. I study the effects on the equity market, proxied by bid-ask spreads and stock volatility, and the credit market, proxied by bond and CDS spreads. The results show that the level of discretionary accounting affects information asymmetry on the equity market, mainly through the effect on bid-ask spreads. Additional tests suggest that these effects are solely generated by the level of discretionary loan loss provisions. I find some evidence that the uncertainty in the level of discretionary accounting has a similar effect on the equity market, however these results are weak to alternative model specifications. I am unable to empirically support any effect on the credit market. My results should be of interest to standard-setters to ensure that financial accounts provide information that support investors' decisions. The results also suggest that banks are able to lower their cost of equity capital by providing high quality information.