THE EFFECTS OF TRANSPARENCY ON THE STABILITY OF INTERNATIONAL
BANKS
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ABSTRACT
Banks have an important role to play in an economy, resource allocation being the primary
function of banks. The financial crisis of 2007 to 2008 has raised questions on the stability of
the financial sector since it affected commercial lending drastically. Banks are deemed to be
less transparent relative to other non-financial firms operating within an economy, even though
they face the same kind of competition and corporate governance issues like non-financial
firms. Thus, making it tough for investors to determine the financial performance and position
of banks. This is because loanable funds are the largest asset group for banks, which makes the
anking sector important to be researched on. It is therefore essential to understand the effect
of transparency on bank stability. Mixed results are found on whether transparency is beneficial
or harmful to bank stability. Research shows that accounting standard setters are in favour of
transparency while bank regulators are against it. The results could have policy implications,
in that, an optimal level of transparency could be identified.
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1. Introduction
The literature review discusses the benefits and costs of transparency on the stability of banks
around the world. Google scholar and SSRN e-journal has been widely used to search for
articles that relate to banks. Journals selected include journal of economics, journal of financial
intermediation and journal of financial economics. The Australian Business Deans Council
(ABDC) has been used to check the rankings of these journals. Search terms included bank
transparency, bank stability, banks, similarity with non-financial firms. The focus was on
commercial banks and non-financial firms have been excluded from the study. The discussion
on the transparency does not identify the elements of financial reporting that affect stability.
1.1 Banks: Background discussion
Banks plays a number of important roles in a country including resource allocation, monitoring
investments, diversification, managing risks and providing services to businesses and
households for day-to-day transactions (Bushman XXXXXXXXXXHowever, due to the financial crisis
that took place in the period between 2007 to 2008 resulted in the collapse of a few commercial
and investment banks such as Lehman Brothers, Me
il Lynch and Wachovia (Barth and
Landsman XXXXXXXXXXAn outcome of the financial crisis was that the banks faced challenges on
which commercial lending is dependent.
Banks, like non-financial firms must face competition and corporate governance issues.
However, in the case of financial statement presentation, the composition of the balance sheet
is quite different from those of non-financial sectors. Tayi and Leonard XXXXXXXXXXin their study
describe loanable funds to be the raw material of a bank that are based on private information.
Thus, it has been asserted that outside investors face difficulties in valuing bank assets
(Flannery, Kwan and Nimalendran XXXXXXXXXXSeveral researches conducted have justified the
anking industry to be informationally opaque relative to non-financial industries, which could
have either a beneficial or bad effect on bank stability (Morgan 2000; Blau, Brough and
Griffith 2016; Fosu et al. 2017).
1.2 Bank transparency and Bank stability
Bank transparency has been defined by Bushman (2016, p-129) as “the availability to outside
stakeholders of relevant, reliable information about the periodic performance, financial
position, business model, governance, and risk of banks.” On the other hand, bank stability is
ased on the activities of all banks since they are linked to or independent on each other.
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Brunnermeier et al XXXXXXXXXXdefines bank stability as “the absence of banking crisis achieved
through the stability of all banks in the banking system or sector.”
Transparency occurs when information disclosed is effective in reaching the market and it
depends on users ability to adequately interpret the information provided (Freixas and Laux
2011). However, there have been contradicting beliefs between bank regulators and accounting
egulators on the extent to which transparency enhances bank stability. Bank regulators argue
that bank transparency may pose threats to banking stability whereas accounting regulators
advocate for transparency since it limits income smoothing (Gaston and Song XXXXXXXXXXThere is
a conflict between the goals of bank regulators who underline the importance of sound and safe
anks and accounting standard setters who prioritize transparency of financial statements.
1.3 Positive effects of transparency on Bank Stability
Transparency plays a major corporate governance role. It has been asserted that banks are
elatively less transparent than other non-banking firms (Morgan XXXXXXXXXXThus, giving rise to
agency problems which is as a result of information asymmetry. Asymmetry occurs because
managers would have better firm specific information than outsiders and managers are unlikely
to report information that is detrimental to them, including poor performance or bad news
(Ve
ecchia XXXXXXXXXXTherefore, publicly available information is used to monitor the actions and
performance of top executives through incentive compensation contracts that is used to align
interests of investors and managers (Bushman and Smith XXXXXXXXXXThus, banks should
communicate their financial position and performance in a timely manner to enable users make
ational decisions (Admati and Pfleiderer 2015).
Enhancing transparency could also reduce the number of bank panics that occur in an economy.
Huang and Gorton XXXXXXXXXXprovide evidence of bank panics between small and large banks. In
their study, it is shown that banks in the United States that are large and well diversified are
less prone to bank failures and panics. Bank panics results from a situation whereby depositors
monitoring the banks, lack information about the bank assets’ value and during recessions they
withdraw from banks. This occurs because depositors are unaware of banks engaging in moral
hazard. Thus, transparency is a means to mitigate panics and roll over risks by reducing the
uncertainty about the solvency of individual banks (Ratnovski 2013).
Furthermore, market discipline is viewed as a process through which market participants
monitor the behaviour of banks and transparency plays an essential role in fostering it
(Bushman and Williams XXXXXXXXXXIn a study conducted by Blum (2002), market discipline has
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een measured using subordinated debt, a valuable tool to monitor and reduce risk taking
ehaviour by banks. Subordinate debt holders are the first creditors to bear losses in case banks
take risky investment decisions. As a result, informed investors will demand a higher risk
premium to compensate for the higher risk entailed in their investments.
Granja (2011, p-5) highlights that “disclosure regulation could have a positive effect on
financial development and stability by facilitating the regulatory efforts to wind down a
distressed banking system.” It has been asserted that higher bank transparency is beneficial in
the auction process of distressed banks. There are lower costs associated with disclosing more
and disclosure is a means to promote mergers and acquisitions of distressed banks by the
healthy and stable banks.
Similar views regarding benefits of disclosure information has been shown by Peek,
Rosengren, and Jordan XXXXXXXXXXThey state that supervisory disclosure provides valuable
information not only for the bank making the announcement but also gives an idea about the
health of banks in the same region with similar portfolios and risks. They conclude that
enhanced transparency can improve resource allocation in the banking industry.
1.4 Negative effects of bank transparency on bank stability
Considering the dark side, transparency could cause market illiquidity. Holmström (2008)
gives an example of a company selling wholesale diamonds to explain how transparency may
not be beneficial to a firm. Diamonds are placed in packets that customers are prohibited to
investigate, and they are sold based on take it or leave it. Holmström XXXXXXXXXXargues that if
uyers could inspect the packets to get a better estimate of their value, it would either slow
down trade or halt trade completely. Thus, eliminating adverse selection problems in the
market.
Even though transparency is important in corporate governance issues (Bushman and Smith
2003), it may not enhance financial stability. In a study conducted by Fahlen
ach and Stulz
(2010) on ninety eight commercial and investments in USA found no evidence of higher stock
eturns during the crisis despite better alignment of Chief Executive Officers (CEOs) and
shareholders of banks. Instead, some evidence of worse stock returns and decreased return on
equity was found, even though the interests of bank CEOs and shareholders were better aligned.
Their results show good corporate governance in banks, however, conflicting with the financial
stability of banks.
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A study done by Chen and Hasan XXXXXXXXXXinvestigates the relationship between transparency of
anks and the fragility of the banking system predict that “contagious bank runs are more likely
to occur when the co
elation between banks’ return is higher.” Small and weaker banks are
likely to suffer bank runs and this negatively affects the stability of the banking system since
depositors are likely to withdraw from all banks when they have information relating even to
just one bank.
In relation to bank runs, Mo
ison and White XXXXXXXXXXshow that even when the return on assets
in which two banks invest are unco
elated, the failure of one bank may cause bank runs
affecting the second bank. Contagion bank runs occur because depositors lose confidence in
the bank regulators competence. Even though, Chen and Hasan XXXXXXXXXXand Mo
ison and White
(2013) both show that bank runs cause instability in the banking sector due to contagious bank
uns, they use different factors to analyse their results. The latter show that inte
ank lending
and co
elation in returns on banks are described as the sources of contagion, however, there is
another factor that should be considered, that is, common regulator of these banks. Having high
co
elation in returns is not enough to explain bank runs, instead having a common regulator
affects them.
It has been asserted that bank stability is disrupted by bank runs. However, the factors
influencing bank runs is not clear. On the one hand, it is argued that small banks are more
vulnerable to bank runs, while some argue that regulators competence causes bank runs to
occur. Furthermore, Similar to Huang and Gorton XXXXXXXXXXfindings, weaker banks are more
prone to bank runs. However, there seem to be contradicting views on whether improvements
in transparency could increase the chance of inefficient contagious runs on other banks (Chen
and Hasan 2006) or reduce it.
1.5 Conclusion
Banks are important due to its significant role of resource allocation in an economy (Allen and
Santomero XXXXXXXXXXBanks financial statements are different from non-financial firms because
loans form an important part of their assets. Thus, making the banking sector less transparent
due to the asymmetric information between banks and depositors (Beatty and Liao XXXXXXXXXXIt is
therefore important to understand the effects of transparency on banking stability.
Several benefits of bank transparency have been highlighted above, including improved
corporate governance, enhancing market discipline and reducing costs associated with bank
auctions. These benefits have an impact on bank stability because information asymmetry
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educes between banks and investors. However, a couple of disadvantages have also been
shown when transparency is enhanced, these include, contagious bank runs, lack of confidence
in regulator competence, slower trade and illiquid markets.
Accounting Standard setters and bank regulators have differing opinions on whether
transparency hinders or enhances stability in bank (Gaston and Song XXXXXXXXXXAccording to
Bushman and Williams XXXXXXXXXXfinancial reporting aims to provide information to outsiders
about the firm to enable them make rational decisions. On the other hand, bank regulators aim
to reduce the risk levels to which depositors are exposed to and to mitigate bank risks (Rochet
2005). It is thus, unclear whether transparency negatively or positively affects bank stability.
Bank runs have been found to be a drawback of increased transparency. However, the factors
influencing bank runs is unclear. Some studies show that high co
elation of returns is a cause
of bank runs, while others argue that even when unco
elated bank returns are reported bank
uns are still present. Furthermore, the role and reputation of a common regulator is believed
to cause bank runs. When a bank fails, other banks under the same regulator are deemed to
suffer causing bank runs across all banks with the common regulator.
Information disclosure has been found to enhance resource allocation in the banking sector
since supervisory announcements reflects the status of other banks with similar portfolios.
Thus, transparency represents positive spill over effects (Peek, Rosengren and Jordan 2000)
ather than representing contagion (Chen and Hasan 2006).
Thus, the conflicting views on transparency creates demand for further research to be
undertaken. This would provide insights on whether transparency is healthy or detrimental for
the banking system and in which scenarios does transparency affect Australian banks. The
mixed results could have policy implications, since an optimal level of transparency needs to
e identified. Another potential area for research includes determining the effects of financial
eporting quality in reducing information asymmetry in banks, this is because