What and how to disclose when facing banking crisis

Transparency is crucial for financial stability and preventing banking crisis. But what information should be disclosed? New research shows that revealing specific information can be the key

By Putro Harnowo, Senior Content Manager, China Business Knowledge @ CUHK

The world is still grappling with the shockwaves triggered by the rapid collapse of the Silicon Valley Bank in March 2023. Its risky investments had far-reaching implications, causing a domino effect in the financial markets with the seizure of Signature Bank and First Republic Bank by US regulators and the enforced merger of Credit Suisse with UBS in Switzerland.

The latest disaster made it the worst crisis in the US and Europe since the global financial crisis of 2007–2008. Both catastrophes have sparked a global discussion on whether and how regulators should disclose the results of the stress tests of individual financial institutions, mainly focusing on finding the best way to disclose bank-specific information that can prevent widespread panic and simultaneous withdrawals, known as systemic bank runs.

Public disclosure of bank-specific information has subsequently become a regular occurrence. However, disclosing overall information without considering the strategic complementarity between investors of different banks can increase systemic risk. When investors receive the same information about all banks, they may act similarly, causing simultaneous runs on multiple banks and reducing liquidity in the system.

“The financial system is highly interconnected, and there is strong contagion among investors,” says Luo Dan, an Assistant Professor in the Department of Finance at the Chinese University of Hong Kong (CUHK) Business School. “Besides the typical requirement for disclosures in other industries, disclosures about the financial system need to take contagion into consideration. For this reason, it is not the case that more transparency is always desirable.”

Much previous research primarily focuses on the disclosure of overall conditions while overlooking the impact of systemic risk and the consequent strategic interdependence among investors from various banks. Consequently, they fail to acknowledge optimal disclosure depending on the nature of bank-specific information.

To address this gap, Professor Luo and Dai Liang, Assistant Professor of Economics at the School of Management and Economics of CUHK Shenzhen, as well as Professor Yang Ming of University College London, investigated the implication of contagion for information disclosure and how the disclosure of different kinds of bank-specific information affects the stability of a banking system facing systemic risk.

Such risk stems from the interdependence of banks in the financial system, which means runs on one bank will adversely affect other banks. Considering all the interconnectivity within the banking system, they identified types of information that should and should not be disclosed to promote financial stability, as well as when those different types of information should be released.

Better safe than sorry

In their research paper, Disclosure of bank-specific information and the stability of financial systems, Professor Luo and the team focused on systemic vulnerability and idiosyncratic shortfall of funds. Systemic vulnerability is the risk that the bank’s failure could have a significant negative impact on the stability of the financial system as a whole. Meanwhile, a bank’s idiosyncratic shortfall corresponds to cash and cash equivalents or to non-performing loans of little systemic consequence.

Using a two-factor model based on the macro-finance and asset-pricing literature, the researchers found that the disclosure of systemic vulnerabilities can mitigate systemic bank runs, but the disclosure of idiosyncratic shortfalls cannot. This happens because, in systemic vulnerabilities, the risk could be shifted away from the most vulnerable banks to the less vulnerable ones to reduce the negative impact on the entire system. However, disclosing only idiosyncratic shortfalls doesn’t have the same effect.

“If the regulator’s goal is to promote financial stability, then how much information about individual banks should be disclosed through stress tests depends on the type of information,” says Professor Luo. “In particular, the regulator should disclose finer information about banks’ exposure to systemic risk but coarser information about banks’ idiosyncratic shortfalls of funds.”

When there is a significant impact from systemic risk, the best way to disclose specific information about individual banks is to observe how the overall quality of the banking system is declining. In this scenario, a banking crisis occurs in two stages: first, a large number of banks experience runs at the same time, and then the remaining banks face runs gradually over time.

“Besides the typical requirement for disclosures in other industries, disclosures about the financial system need to take the contagion into consideration.”

Professor Luo Dan

To get to know what and how bank-specific information should be disclosed to enhance financial stability, the researchers further characterised the properties of optimal disclosures. Instead of proposing a specific disclosure model, Professor Luo and the team pointed out that such disclosure depends on the tradeoff between the two effects of stress tests: market discipline and coordination failure.

Market discipline refers to the ability of investors to use information to make informed decisions about which banks to invest in or withdraw funds from. Coordination failure refers to the risk that investors may all withdraw funds from a bank simultaneously, leading to bank runs and potentially systemic risk. The study found that optimal disclosure depends on the relative strength of these two effects.

When market discipline dominates, more information should be disclosed to increase transparency and allow investors to make informed decisions. However, when coordination failure dominates, disclosing too much information can actually increase systemic risk by causing investors to withdraw funds from multiple banks at the same time.

Wait, see, and maybe run

Understanding the relationship between banks and the strategic uncertainty faced by investors is also crucial in times of crisis. For this purpose, the researchers introduced the concepts of separation, entanglement, and adjacency among banks based on financial condition, risk profile, or other relevant factors to determine the level of their vulnerability to systemic risk and the likelihood of bank runs.

“Investors are concerned about other investors’ decisions when they decide whether to keep money in their banks or withdraw,” says Professor Luo.

“When the disclosure induces separation between two banks, their respective investors are almost sure about each other’s decisions, and there is no strategic uncertainty. When the disclosure induces entanglement, substantial strategic uncertainty remains between the investors of different banks, which can be fine-tuned by the disclosure of bank-specific information. And adjacency is the knife-edge case in between.”

The optimal level of disclosure also depends on the physical strength of the banks and their systemic vulnerabilities. Physically weak banks should be fully revealed and “sacrificed” to increase market discipline and prevent coordination failure. However, in the presence of systemic risk, more banks with low systemic vulnerabilities should also be fully revealed to increase transparency and prevent bank runs.

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“This study focuses on the impact of information disclosure in a relatively short horizon and thus assumes that banks’ fundamentals do not change much,” says Professor Luo. “In longer horizons, banks may respond to information disclosure by adjusting business strategies.”

Furthermore, Professor Luo notes that future research can take banks’ responses into consideration and explore the longer-term impact of information disclosure.