Observable but Not Verifiable: Audit Quality and Financial Stability

Audit quality is an institutional outcome, not a trait of auditors. A regime disciplined mainly by inspectability and liability rewards provable evidence and tends to crowd out the soft information auditors observe but cannot prove. The paper traces this bias to the regulatory rewarding of ex-post verifiability at a time when accounting has turned predictive, and argues that in banking it becomes systemic: because auditors across banks wait for the same verifiable triggers, dispersed, bank-specific deterioration is filtered out and recognition is synchronized, turning staggered adjustments into a common, abrupt shock. The relevant contrast is not early versus late recognition but gradual versus abrupt. The policy implication is not to turn auditors into supervisors, but to design standards, liability, inspection, and supervisory communication so that judgment over information observable before it is verifiable is protected rather than taxed.