Transparency, Accounting Discretion, and Bank Stability

TLDR: In this article, Mehran and Mollineaux find that while credible public information about individual banks can enhance the ability of regulators and market participants to monitor and exert discipline on banks' behavior, there are also endogenous costs associated with transparency that can be detrimental to the banking system.

Abstract: 1.INTRODUCTIONBank transparency can be defined as the availability to outside stakeholders of relevant, reliable information about the periodic performance, financial position, business model, governance, and risks of banks. Outside stakeholders include depositors, investors, borrowers, counterparties, regulators, policymakers, and competitors. Transparency is the joint output of a multifaceted system whose component parts collectively produce, gather, and validate information and disseminate that information to participants outside the bank. Components include mandated, publicly available accounting information; information intermediaries such as financial analysts, credit rating agencies, and the media; and supervisory disclosures (including stress-test disclosures), banks' voluntary disclosures, and information transmitted by securities prices (Bushman and Smith 2003; Bushman, Piotroski, and Smith 2004). While access to information is a necessary condition for transparency, transparency also relies on the active efforts of information receivers, as dictated by their incentives to gather, interpret, and incorporate available information into decision-making processes (see, for example, Freixas and Laux [2012]; Mehran and Mollineaux [2012]).1An important unresolved issue is the extent to which bank transparency promotes or undermines bank stability. A large theory literature explores bank transparency and how it affects the risk profile of individual banks and the financial system as a whole. Overall, this literature finds that while credible public information about individual banks can enhance the ability of regulators and market participants to monitor and exert discipline on banks' behavior, there are also endogenous costs associated with transparency that can be detrimental to the banking system.Consider the positive effects of transparency. Transparency plays a fundamental corporate governance role in all industries, supporting monitoring by boards of directors, outside investors, and regulators, as well as the exercise of investor rights granted by existing laws. Credible, publicly available information is used to assess and reward the actions and performance of top executives and is incorporated into the design of incentive compensation contracts and decisions about when to fire executives (Bushman and Smith 2001; Armstrong, Guay, and Weber 2010). For banks, however, the role of information transcends the classic governance objective of aligning the behavior of executives with the interests of shareholders. Banks face distinctive governance challenges because they must balance the demands of being value-maximizing entities with those of serving the public interest (Mehran and Mollineaux 2012; Mehran, Morrison, and Shapiro 2011). High leverage combined with subsidized deposit insurance, government guarantees, and bank opacity creates motives and opportunities for risk taking that can be optimal from the point of view of shareholders, given limited liability, but not from that of the economy as a whole if it raises systemic risk through an increased probability of failure.2For example, Anginer et al. (2014) find that for an international sample of banks, shareholder-friendly corporate governance is positively associated with bank insolvency risk and, consistent with increased risk taking, is also associated with a higher valuation of the implicit insurance provided by the financial safety net. Also consistent with a conflict between firm-level governance and bank stability concerns are the findings of Fahlenbrach and Stulz (2011) that during the financial crisis of 2007-08, the price performance of bank shares was worse for banks in which the CEO's incentives were better aligned with shareholders' interests ex ante.The banking literature suggests that, in addition to supporting corporate governance mechanisms, transparency can promote bank stability by enhancing the market discipline of banks' risk-taking decisions (see, for example, Rochet [1992]; Blum [2002]; Cordella and Yeyati [1998]). …