Running from the spotlight? Bank opacity and financial crises

In his BSE Working Paper (No. 882) “Bank Opacity and Financial Crises”, Joachim Jungherr studies a model of bank transparency. Why do banks choose to hide their risk exposure from the public? And should policy makers force banks to be more transparent? In the model, the answer is “yes”, if the composition of a bank’s asset holdings is proprietary information. In this case, policy makers can increase financial stability by imposing public disclosure requirements (such as the ones specified in Pillar Three of Basel II). However, full transparency maximizes neither efficiency nor stability. The socially desirable level of transparency trades off market discipline with a stabilizing role of bank opacity as an insurance device against bank runs.

Why is bank transparency relevant?

Banks’ risk exposure is hard to judge for the public. Supervisors try to address this problem by regulating how much information banks need to reveal about their investment behavior. Transparent bank balance sheets are supposed to help financial markets to discipline bank risk taking. During the recent financial crisis, public information about the risk exposure of individual banks was particularly scarce. Regulators in the U.S. and in Europe responded with the publication of bank stress test results. Former Fed Chairman Ben Bernanke called the 2009 U.S. Stress Test one of the critical turning points in the financial crisis.

A simple model of bank transparency

In the model, a bank chooses a level of transparency by selecting the probability that its portfolio choice becomes public information. Any value between zero (complete opacity) and one (full transparency) is possible. Banks compete for household savings in order to invest them in safe and risky projects. A bank chooses the level of transparency which maximizes its market share. Banks are subject to roll-over risk, as some part of their funding is short-term debt. If short-term creditors refuse to roll over, there is a bank run and projects need to be liquidated prematurely. This is why bank runs are socially costly.

The role of market discipline

In the banking literature, market discipline is commonly deemed useful because of a misalignment of incentives between the bank and the ultimate bearers of the risk (depositors, creditors, shareholders, or the deposit insurance system). The author shows that transparency affects risk taking even if the bank’s and outsiders’ interests are perfectly aligned. The reason is that an opaque bank faces a credibility problem. During a crisis episode, banks which are believed to have chosen a safe portfolio will not face a run. Given that creditors believe that an opaque bank is prudent, there is no reason for this bank to actually act prudently as its bank run risk is low anyway and its actual risk exposure is not observed. In equilibrium, creditors anticipate the opaque bank’s incentive to increase risk taking. Only by choosing a high level of transparency, a bank can commit to a prudent portfolio choice.

Incentives for bank opacity

If market discipline is so important, why do banks choose not to be as transparent as possible? One reason is that bank opacity serves as an insurance device against bank runs. If banks’ risk exposure is unobservable, short-term creditors cannot disentangle weak banks from strong ones. “All cats are grey in the dark.” Through opacity, banks insure each other against the risk of picking the wrong portfolio. Transparency prevents this risk sharing mechanism. This phenomenon that public information reduces risk sharing opportunities is sometimes called the Hirshleifer effect.

A second incentive for opacity is that a bank’s portfolio choice may be proprietary information. If a bank chooses its portfolio using private information, disclosure of its loan portfolio would reveal its informational advantage to competitors. Opacity prevents information leakage to rival banks. By reducing transparency, a bank may hurt its competitors more than it hurts itself. In the presence of information spillovers of this kind, the level of transparency which maximizes a bank’s market share is different from the one which maximizes the bank’s value.

Competition and bank opacity

A bank’s choice of transparency is determined by three forces:

  1. market discipline
  2. the Hirshleifer effect
  3. information spillovers

The last force becomes weaker as the number of banks increases, since the information contained in any given bank’s portfolio choice becomes less important for its competitors. For this reason, the equilibrium choice of transparency is increasing in the number of banks. This is an interesting result of the model, since empirically bank competition has indeed been found to increase bank transparency.

Policy implications

If banks choose their portfolio using private information, their portfolio choice is proprietary information. A bank can increase its market share by reducing transparency below the level which maximizes its own value, because this hurts its competitors by even more than it hurts itself. Banks behave as in a prisoner’s dilemma and the equilibrium level of transparency is too low. Minimum public disclosure requirements (such as the ones specified in Pillar Three of Basel II) are beneficial in this case, as an increase in transparency improves market discipline and reduces the risk of bank runs. However, full transparency maximizes neither efficiency nor stability. The socially desirable level of bank transparency trades off market discipline with the stabilizing role of the Hirshleifer effect.