The Effect of the Balance Sheet Approach on the Usefulness of Accounting Information in Assessing Bank Default Risk

This study investigates the association between the balance sheet approach, where financial reporting focuses on asset and liability valuation, and the usefulness of the capital adequacy ratio in the evaluation of bank default risk by credit rating agencies. We examine Japanese banks, which play the central role in the Japanese economy, whose capital adequacy ratios are affected by fair value measurement under the balance sheet approach. We adopt Demerjian’s approach to develop a bank-level measure of balance sheet focus. Although we find a significant positive correlation between the slack of the regulatory capital adequacy ratio and issuer rating, this positive correlation weakens significantly as a bank’s dependence on the balance sheet approach increases. Our results suggest the balance sheet approach makes financial reporting less useful for measuring bank risk.