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Home > Capital Markets Best Practice > Banking Transparency and the Robustness of the Banking System

Capital Markets Best Practice

Banking Transparency and the Robustness of the Banking System

by Solomon Tadesse

Executive Summary

  • The global financial crisis of the new millennium has brought to light the inherent fragility of the financial system and made more urgent the need for policy reforms to enhance its robustness against future shocks.

  • The opaque world of securitization and credit derivatives in subprime mortgages, which served as the breeding ground for the crisis, has brought attention to the age-old question of whether enhancing transparency can promote the stability of the financial system.

  • The objective of this article is to provide a short review of the issues surrounding the relationship between banking transparency and the stability of the banking system.

  • The theoretical as well as the empirical case for transparency as an enhancer of banking system robustness is not without controversy.

  • However, despite conflicting views, there is a consensus that transparency, while not a panacea against systemic turbulence in financial systems, plays a significant role in enhancing banking system stability.

Introduction

Crises have been a common feature of banking systems for a long time—the United States alone experienced 11 banking panics between 1800 and the beginning of World War I (Beim and Calomiris, 2001). The crises of recent times have, however, been rather severe. The full range of costs linked to the 2007–09 financial crisis may not be easily estimable. While initial gross government commitments to deal with the crisis have reached between 20% and 30% of GDP in developed markets (Schildbach, 2010), the effective fiscal outlays so far have amounted to 3.5% of GDP in G20 countries, with gross output losses projected to be much higher. In earlier crises the costs of bailing out troubled banks in a banking crisis ranged between 20% and 50% of a country’s GDP, with a resolution time that could extend up to nine years (Honohan and Klingebiel, 2000). Hoggarth and Saporta (2001) report the average fiscal costs of resolving a banking crisis to be about 16% of GDP, with cumulative real output losses stemming from a banking crisis put at more than 17% of GDP. As an example, the cost to Indonesia of resolving the crisis of 1997 is estimated to have been 50% of its GDP.

The global crisis, coupled with the massive recurrent financial turbulence of the late 1990s, brought to the fore the public debate on the potential role of increased disclosure and transparency in strengthening market discipline in relation to the financial sector. In its report to the G7 finance ministers, the Financial Stability Forum (FSF), for example, calls for financial institutions to strengthen their risk disclosure and for supervisors to improve risk disclosure requirements under Pillar 3 of Basel II (FSF, 2008). Enhanced transparency via greater disclosure of accurate and timely information about constituent financial institutions is believed to facilitate an objective assessment of the financial health of banks by market participants, inducing market discipline that could reduce the likelihood of systemic turbulence in the banking sector.

Banking Transparency

The Bank for International Settlements (BIS) defines transparency as public disclosure of reliable and timely information that enables users to make an accurate assessment of a bank’s financial condition and performance, business activities, risk profile, and risk management practices (Basel Committee on Banking Supervision (BCBS), 1998). Information that induces transparency is believed to have the characteristics of being comprehensive, timely, reliable, comparable, and material. Enhanced disclosure may improve bank performance and banking system stability for a number of reasons. First, disclosure and transparency prevent banks from taking excessive risks, as market discipline reduces the funding base of imprudent banks. Second, if crises happen, losses would be less costly in high-disclosure regimes than otherwise. Disclosure of bank problems could lead to quick recovery from crisis, thus reducing realized losses (see, for example, Rosengren, 1999). It would force banking consolidation, transfer of problem assets, and closure of insolvent banks, speeding the recovery of the banking sector.

In general, disclosure is regulated in both the corporate and banking sectors. Regulated disclosure is justified by the existence of market failure that results from either asymmetry of information or externalities. Bank runs and panics have been attributed to informational asymmetries between banks and depositors (Bryant, 1980; Bernanke and Gertler, 1990), where uninformed depositors precipitate a bank run due to fear of real or imagined bank failure. This can then be spread, again due to asymmetry, to other banks—even healthy ones—endangering stability. Mandated disclosure places bank depositors, other market participants, and insiders on an equal footing, thereby reducing runs and panics. At the same time, disclosure would also reduce the incentives for banks to undertake excessive risk through the mechanism of market discipline.

Information can be viewed as a public good subject to free-rider problems. In banking, due to the central role the banking system plays in the economy, the social benefits of bank-specific information outweigh the private benefits to the bank, generating externalities. Greater disclosure may, however, also engender negative informational externalities. Disclosure may lead to an interpretation of bank information as indicative of widespread problems in the banking sector, leading to bank runs and collapses in stock markets.

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Further reading

Books:

  • Beim, David O., and Charles W. Calomiris. Emerging Financial Markets. New York: McGraw-Hill/Irwin, 2001.
  • Calomiris, Charles W., and Gary Gorton. “The origins of banking panics: Models, facts, and bank regulation.” In R. Glenn Hubbard (ed). Financial Markets and Financial Crises. Chicago, IL: University of Chicago Press, 1991; 109–174.
  • Rosengren, E. “Will greater disclosure and transparency prevent the next banking crisis?” In William C. Hunter, George G. Kaufman, and Thomas H. Krueger (eds). The Asian Financial Crisis: Origins, Implications and Solutions. Boston, MA: Kluwer Academic, 1999.

Articles:

  • Barth, James R., Gerard Caprio, Jr, and Ross Levine. “Bank regulation and supervision: What works best?” Journal of Financial Intermediation 13:2 (April 2004): 205–248. Online at: dx.doi.org/10.1016/j.jfi.2003.06.002
  • Bernanke, Ben, and Mark Gertler. “Financial fragility and economic performance.” Quarterly Journal of Economics 105:1 (February 1990): 87–114. Online at: www.jstor.org/stable/2937820
  • Bliss, Robert R., and Mark J. Flannery. “Market discipline in the governance of U.S. bank holding companies: Monitoring vs. influencing.” Review of Finance 6:3 (2002): 361–396. Online at: dx.doi.org/10.1023/A:1022021430852
  • Bryant, John. “A model of reserves, bank runs, and deposit insurance.” Journal of Banking and Finance 4:4 (1980): 335–344. Online at: dx.doi.org/10.1016/0378-4266(80)90012-6
  • Calomiris, Charles W., and Joseph R. Mason. “Contagion and bank failures during the Great Depression: The June 1932 Chicago banking panic.” American Economic Review 87:5 (December 1997): 863–883. Online at: www.jstor.org/stable/2951329
  • DeYoung, Robert, Mark J. Flannery, William W. Lang, and Sorin M. Sorescu. “The information content of bank exam ratings and subordinated debt prices.” Journal of Money, Credit and Banking 33:4 (November 2001): 900–925.
  • Gorton, Gary. “Banking panics and business cycles.” Oxford Economic Papers 40:4 (December 1988): 751–781. Online at: oep.oxfordjournals.org/content/40/4/751.full.pdf+html
  • Jordan, John. S, Joe Peek, and Eric S. Rosengren. “The market reaction to the disclosure of supervisory actions: Implications for bank transparency.” Journal of Financial Intermediation 9:3 (July 2000): 298–319. Online at: dx.doi.org/10.1006/jfin.2000.0292
  • Kaufman, George G. “Bank contagion: A review of the theory and evidence.” Journal of Financial Services Research 8:2 (April 1994): 123–150. Online at: dx.doi.org/10.1007/BF01053812
  • Krishnan, C. N. V., P. H. Ritchken, and J. B. Thomson. “On credit-spread slopes and predicting bank risk.” Journal of Money, Credit and Banking 38:6 (September 2006): 1545–1574.
  • Nier, Erlend, and Ursel Baumann. “Market discipline, disclosure and moral hazard in banking.” Journal of Financial Intermediation 15:3 (July 2006): 332–361. Online at: dx.doi.org/10.1016/j.jfi.2006.03.001
  • Penas, María Fabiana, and Günseli Tümer-Alkan. “Bank disclosure and market assessment of financial fragility: Evidence from Turkish banks’ equity prices.” Journal of Financial Services Research 37:2–3 (June 2010): 159–178. Online at: dx.doi.org/10.1007/s10693-009-0076-5
  • Tadesse, Solomon. “The economic value of regulated disclosure: Evidence from the banking sector.” Journal of Accounting and Public Policy 25:1 (January–February 2006): 32–70. Online at: dx.doi.org/10.1016/j.jaccpubpol.2005.11.002

Reports:

  • Basel Committee on Banking Supervision (BCBS). “Enhancing bank transparency: Public disclosure and supervisory information that promote safety and soundness in banking systems.” Bank for International Settlements, September 1998. Online at: www.bis.org/publ/bcbs41.htm
  • BCBS. “The new Basel capital accord.” Consultative document, Bank for International Settlements, April 2003. Online at: www.bis.org/bcbs/bcbscp3.htm
  • Caprio, Gerard, and Daniela Klingebiel. “Episodes of systemic and borderline financial crises.” Research dataset, World Bank, January 2003. Online at: go.worldbank.org/5DYGICS7B0
  • Financial Stability Forum (FSF). “Report of the Financial Stability Forum on enhancing market and institutional resilience.” FSF, April 7, 2008. Online at: www.financialstabilityboard.org/publications/r_0804.pdf
  • Hoggarth, Glenn, and Victoria Saporta. “Costs of banking system instability: Some empirical evidence.” In Financial Stability Review. Bank of England, June 2001. Online at: www.bankofengland.co.uk/publications/fsr/2001/fsr10.htm
  • Honohan, Patrick, and Daniela Klingebiel. “Controlling the fiscal costs of banking crises.” Policy Research Working Paper 2441. World Bank, 2000. Online at: tinyurl.com/5t6bfp5
  • Schildbach, Jan. “Direct fiscal cost of the financial crisis: Probably much lower than feared.” Deutsche Bank Research, May 14, 2010. Online at: tinyurl.com/6ezbxd2 [PDF].

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