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)....
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