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The Bright Side of Transparency: Evidence from Supervisory Capital Requirements

The Bright Side of Transparency: Evidence from Supervisory Capital Requirements

Over the past decade, the role of banking supervisors has become broader and more complex. The unconventional nature and growing scale of interventions—as seen again during the COVID-19 pandemic—have brought additional scrutiny and increasing responsibilities that have led to a stronger demand for supervisors to deliver clarity and reduce uncertainty over their actions.

In turn, bank regulators and supervisors have stressed the importance of enhanced transparency as a key instrument to increase banks’ accountability and allow market participants to assess banks’ risks. Ultimately, transparency enhancement aims at improving the soundness and resilience of the financial system to raise capital allocation efficiency. From a theoretical standpoint, the advocates of complete transparency argue that the disclosure of banks’ information allows financial markets to discipline risk-taking behaviour by exerting market pressure through the pricing of publicly available information. Accordingly, this allows to monitor for excessive risk-taking or mis-governance, thereby reducing agency frictions within the bank and promoting greater financial stability and sustainable growth. In contrast, a separate strand of literature claims that such disclosure exercises may have unintended costly consequences, such as the distortion of capital markets or the triggering of bank runs (Goldstein and Sapra (2014); Goldstein and Leitner (2018); Alvarez and Barlevy (2021); Berlin (2004), Leitner (2014)).

Since the 2008 financial crisis and given the apparent inability of private credit rating agencies (CRAs) to deliver accurate assessment of bank creditworthiness, many supervisors started disclosing additional idiosyncratic information on financial institutions from their own assessment. So far, two key supervisory transparency exercises have received most attention from scholars and policymakers: stress-testing and securitization activities, both providing valuable information about bank liquidity and financial stability risk. Although gathering information to determine banks’ regulatory capital requirements constitutes most of a supervisor’s daily work, much less attention has been devoted to how the disclosure of these regulatory metrics may be useful to investors. For instance, banks may alter their risk-taking behaviour in response to changes in regulatory capital requirements, which can have direct impact on their lending and investment decisions, as evidenced in several studies (Gropp et al. (2018), Berrospide et al. (2019), Favara et al. (2020), Behn et al. (2016), Fraisse et al. (2020), Jimenez et al. (2017)). In addition, regulatory capital requirements may also directly impact market participants as failure to meet those requirements results in restrictions on capital distributions. Both channels shed light on the importance of regulatory transparency to facilitate informed investment and market efficiency.

In our paper, we take advantage of a unique experiment to investigate the implications of public disclosure of regulator risk assessments on asset prices and investors’ risk-sharing. In January 2020, the European Central Bank (ECB) published for the first-time bank-by-bank information as part of its main supervisory risk assessment exercise—the Pillar 2 Requirements (P2R). We study differential effects across banks that were subject to the public disclosure and find that bond prices and cross-border holdings of debt securities are sensitive to new P2R releases as well as to rating gaps between the ECB and private CRAs.

After controlling for private credit ratings, individual P2Rs offer a unique, measurable, and comprehensive insight into the ECB’s private assessment of a bank in terms of overall riskiness and viability. In our paper, we construct a novel measure to quantify the difference between supervisor and private CRA credit assessment of individual banks. Herein, we exploit these supervisory rating gaps to identify the information value and content added by P2R and sort individual banks accordingly. As a matter of fact, the ECB transparency exercise affected banks asymmetrically as some financial institutions were already disclosing their P2R before the system wide publication of January 2020. Using the P2R as an exogenous source of variation, we identify and estimate the impact of the information and transparency channels of supervisory capital requirements on (i) banks’ market-based cost of funding and (ii) private risk-sharing. Our main results reveal that positive rating gaps of newly P2R-transparent banks are associated with (i) an increase in bond prices, (ii) a widening in the set of investors (especially foreign ones), and (iii) a decrease in the concentration of bond holdings.

From a macroeconomic standpoint, we argue that the disclosure of prudential requirements is likely to have long term effects on EU banks. This is in view of the annually regular and mandatory nature of the disclosure policy, which implies a credible long-term commitment to enhanced transparency and public accountability. From a microeconomic perspective, our findings based on bank individual P2R information and the supervisory rating gap confirm our hypothesis that supervisors have specific, idiosyncratic, and valuable knowledge about the banks they directly supervise. Additionally, and from a financial markets perspective, our findings about significant effects on bond prices support the opinion noted by the ESMA that P2R represents price-sensitive information which requires public transparency, as per the EU Market Abuse Regulation, against possibly insider trading of material signalling information. Our results showing investors’ heterogeneous reactions and increased foreign holdings in the newly transparent banks, relative to domestic investors, provide corroborating evidence on the role of informational asymmetries. These findings possibly indicate different incentives and costs of information acquisition, which can be decisive for investors’ portfolio allocation and risk diversification outcomes.

In conclusion, our study suggests that the system-wide P2R disclosure exercise implemented by the ECB in January 2020 has improved transparency to the benefit of European financial markets by making clear and measurable bank-relevant information more easily, publicly available and on a systematic basis. In turn, we emphasize that enhanced transparency frameworks aiming at reinforcing level-playing field supervision can promote greater financial integration as well as efficient risk sharing and capital allocation, which are key to the stability of euro area capital markets.

This post is adapted from the authors’ working paper, ‘The Bright Side of Transparency: Evidence from Supervisory Capital Requirements’, available on SSRN. This paper should not be reported as representing the views of the European Central Bank (ECB) or the International Monetary Fund (IMF). The views expressed are those of the authors and do not necessarily reflect those of the ECB or the IMF.

Nordine Abidi is an Economist at the International Monetary Fund.

Livia Amato is a Research Professional at the University of Chicago: Booth School of Business.

Ixart Miquel-Flores is a Researcher at the Frankfurt School of Finance & Management and a Banking Supervision Analyst at the European Central Bank.

Quentin Vandeweyer is an Assistant Professor of Finance at the University of Chicago: Booth School of Business.

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