Investment opportunity sets, accounting‐based regulatory contracts, and accounting discretion Available to Purchase

Refers to previous research to suggest that US commercial bank managers use discretion to “manage” regulatory capital and that accounting discretion can influence a bank’s investment opportunity set (IOS) and therefore its share price. Challenges the assumption that using accounting discretion to manipulate contracting variables will only result in a redistribution of wealth. Develops a mathematical model based on Feltham and Ohlson (1995) and uses it to explore the bank manager’s optimal investment in risky assets, the constraint on investment choice produced by minimum regulatory capital requirements and how accounting discretion can reduce this. Shows that regulatory requirements do constrain a bank’s IOS but that discretion (e.g. over loan loss provisions) can only mitigate this if dividend and financing policies depend on the discretionary components.