The Strategic Under-Reporting of Bank Risk

We show that banks signicantly under-report the risk in their trading book when they have lower equity capital. A decrease in a bank’s equity capital results in substantially more frequent violations of its self-reported risk levels in the following quarter. These results are consistent with the view that banks under-report their risks to lower their current regulatory capital requirements at the expense of potentially higher future capital requirements that follow if the under-reporting is detected. The under-reporting is especially high during the critical periods of high systemic risk and for banks with larger trading operations. Our results provide evidence that the current regulations give reporting incentives that make the self-reported risk measures least informative precisely when they matter the most.