From Low-Quality Accounting to Financial Crises: Politics of Disclosure Regulation along the Economic Cycle

This paper models interactions between disclosure regulation and the economic cycle, within a positive framework in which politically-sensitive regulators respond to the demands of firms (borrowers) and banks (lenders). We show that accounting quality is lowest prior to a recession, as the increase in the stock of non-performing projects shifts political power toward those favoring less financial transparency. In turn, bad debt accumulates in banks, as lending activity, cost of debt and aggregate uncertainty all increase. When recessionary times become known, borrowers raise accounting quality to offset the deadweight cost of bad investments, leading to credit market contraction.