Since Louis D. Brandeis famously claimed that “…sunlight is the best of disinfectants” (Harper’s Weekly, 20 December 1913), enhanced transparency has been recurrently proposed as a regulatory intervention to prevent bank crises. In the aftermath of the global financial crisis, stress tests emerged as a novel policy tool to enhance disclosure and promote financial stability, and the Basel international banking regulatory framework was reformed with the aim of strengthening banks’ transparency. The current turmoil in the banking sector has renewed the calls for more stringent stress testing of banks’ bond portfolios (e.g. The Economist, 18 March 2023).
General properties of bank transparency regulation
In theory, bank transparency regulation has some attractive features. Transparency involves providing information to market participants about a bank both before and after they provide funds to it. Ex-post information about the low value of a bank’s assets may lead creditors to withdraw their funds or refuse to refinance. The threat of such a rollover crisis may then discipline the bank’s risk taking (Cordella and Yeyati 1998, Ignatowski 2014, Moreno and Takalo 2016, 2022). Ex-ante information about a bank’s financial condition allows investors a better evaluation of its risk position, potentially making the supply of funds to the bank more risk-sensitive and thereby providing market discipline (Hyytinen and Takalo 2002).
On the other hand, bank transparency has two fundamental weaknesses as a policy tool. The first is that banks are inherently opaque (Dang et al. 2017) and they engage in maturity transformation and are therefore subject to various confidence crises. No level of ex-ante transparency, however precise, can eliminate confidence crises arising from investors’ self-fulfilling expectations (Hyytinen and Takalo 2004, Moreno and Takalo 2022). As a result, banks remain susceptible to confidence crises even if they are made more transparent. Moreover, not even perfect ex-post transparency can eliminate depositor runs arising from maturity transformation. As Diamond and Dybvig (1983) demonstrate in their Nobel Prize-winning work, depositor runs can be eliminated via full depositor insurance. But such extensive safety nets would make transparency regulation a moot issue since banks’ creditors would no longer need to pay attention to banks’ financial conditions (Hyytinen and Takalo 2002, Calomiris 2023).
Another weakness is that public disclosure will calm markets only if it provides news that is better than markets’ expectations (Moreno and Takalo 2016). Telling the market that situation is worse than what has been thought may prompt a panic, as the management of Silicon Valley Bank recently learned. On the other hand, information unravelling may prevent regulatory authorities from hiding unfavourable information about banks (Grossman 1981, Milgrom 1981). These challenges came to the fore when the regulatory authorities contemplated the seminal US bank stress test of 2009. As Timothy Geithner recalls, “...Fed officials were reluctant to publicise bank-specific numbers. They feared that publicising...could undermine confidence, prompting investors to run from banks that looked weak. Larry [Summers] and I believed that we needed the fullest plausible disclosure, that even bad news would be better than no news. Investors were already assuming the worst about many banks. And I worried that voluntary disclosures by stronger banks alone could be even more stigmatising to weaker banks than mandatory disclosures for all. I made the case to Ben [Bernanke] and he ultimately agreed, overruling the traditional conservatism of the Fed staff” (Geithner 2014: 346).
Lessons for stress tests design
In recent research (Moreno and Takalo 2022), we address the issue of stress test design when disclosure is mandatory and affects a bank’s cost of raising funding and its risk taking. We argue that regulators must consider banks’ risk-taking incentives before the publication of stress test results and investors’ reactions after the publication. Stringent and precise stress tests help to stabilise the banking sector if the regulatory authorities have effective means to deal with failing banks. This was the case at the time of the first stress tests in the US, where authorities could tap into TARP funds to recapitalise failing banks, thus allowing the implementation of tough and precise stress tests. This feature, together with Geithner’s observation that investors were pessimistic, may explain why the first US stress tests have widely been considered successful. In contrast, if the authorities lack instruments to mitigate the consequences of bank failures, it may be unwise to provide precise stress tests, which may lead investors to shun banks about which the news is bad. The lack of clear fiscal authority to resolve failing banks may explain why the first stress tests of European banks were rather uninformative. Making stress tests more effective provides yet another reason to improve the bank resolution framework in the EU, besides the reasons pointed out by Ignatowski (2014), Reichlin et al. (2021), and Dewatripont et al. (2023).
Incorporating the events before stress tests into their design is a thornier issue. On the one hand, banks anticipating that their cost of funding will increase upon negative stress test results may try to reduce the likelihood of such events by reducing risk taking. On the other, banks anticipating a failure to raise funding due to bad news may take more risk due to limited liability. This moral hazard problem further emphasises the importance of being able to mitigate the consequences of the publication of negative stress test results.
The optimal precision of stress tests also depends on the investors’ ability to observe the riskiness of banks’ asset portfolios when providing funds to banks prior to stress tests. If banks’ asset riskiness is observable to investors, precise stress tests may not be so helpful since they may substitute for market discipline. In contrast, if banks’ asset riskiness is unobservable to investors, precise stress tests are more effective since they enhance market discipline. In practice, riskier banks often pay more for their funding, suggesting that sophisticated investors can assess banks’ asset risk levels. In the case of Silicon Valley Bank, for example, it is quite clear that its asset risk level was observable to those who wanted to look. In some cases, however, asset risk is unobservable. It is likely, for example, that very few people outside of Credit Suisse knew what had been hidden in its balance sheets and derivative positions. These observations suggest that the optimal design of stress tests depends on ex-ante transparency regulations like those included in Pillar 3 of the Basel framework. While ex-ante transparency introduces market discipline, its compliance costs may dilute banks’ charter value and increase their risk-taking incentives (Hyytinen and Takalo 2002). When such costs are significant, high levels of ex-ante transparency should be avoided, and stringent stress tests may be more useful.
Thus, stress tests design must consider multiple factors, and its effectiveness depends on the regulatory framework. Stress tests are more effective if ex-ante transparency is weaker or more costly to comply with. Stringent stress tests should be implemented only if the authorities have effective means to deal with failing banks.
References
Calomiris, C (2023), “That 80s feeling: How to get serious about bank reform this time and why we won’t”, VoxEU.org, 27 March.
Cordella, T, and E L Yeyati (1998), “Public disclosure and bank failures”, IMF Staff Papers 45: 110–131.
Dang, T V, G Gorton, B Holmström, and G Ordoñez (2017), “Banks as secret keepers”, American Economic Review 107: 1005-1029.
Dewatripont, M, P Praet, and A Sapir (2023), “The Silicon Valley Bank collapse: Prudential regulation lessons for Europe and the world”, VoxEU.org, 20 March.
Diamond, D, and P Dybvig (1983), “Bank runs, deposit insurance, liquidity”, Journal of Political Economy 91: 401-419.
Geithner, T F (2014), Stress Test: Reflections on Financial Crises, Random House Books: London.
Grossman, S (1981), “The informational role of warranties and private disclosures about product quality”, Journal of Law and Economics 24: 461-483.
Hyytinen, A, and T Takalo (2002), “Enhancing bank transparency: A re-assesment”, Review of Finance 6: 429-445.
Hyytinen, A, and T Takalo (2004), ”Preventing systemic crises through bank transparency”, Economic Notes 33: 257-273.
Ignatowski, M (2014), “Resolution threats and bank discipline”, VoxEU.org, 20 May.
Milgrom, P (1981), “Good news and bad news: Representation theorems and applications”, Bell Journal of Economics 12: 350-391.
Moreno, D, and T Takalo (2016),“Optimal bank transparency”, Journal of Money, Credit and Banking 48: 203-231.
Moreno, D, and T Takalo (2022), “Precision of public information disclosures, banks’ stability and welfare”, manuscript.
Reichlin, L, A Sapir, and M Dewatripont (2021), “Urgent reform of the EU resolution framework is needed”, VoxEU.org, 16 April.
