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Making Banks Transparent

Posted by on Friday, March 30, 2012 in Articles, Volume 65, Volume 65, Number 2, Volumes.

As the Financial Crisis and the more recent European sovereign debt crisis illustrated, U.S. financial institutions represent uniquely opaque organizations for investors in capital markets. Although bank regulatory policy has long sought to promote market discipline of banks through enhanced public disclosure, bank regulatory disclosures are notoriously lacking in granular, position-level information concerning banks’ credit investments due largely to conflicting concerns about protecting the confidentiality of a bank’s proprietary investment strategies and customer information. When particular market sectors experience distress, investors are thus forced to speculate as to which institutions might be exposed, potentially causing significant disruptions in credit markets and contributing to systemic risk. Together with the failure of bank regulators to monitor bank risk-taking prior to the Financial Crisis, these concerns have prompted renewed calls for making financial institutions more transparent.

Contrary to current skepticism, it is possible to balance transparency and proprietary interests. By turning to the insights of credit risk modeling, this Article argues that redesigning bank disclosures to facilitate credit modeling by market participants has the potential to meaningfully increase market discipline while minimizing the disclosure of sensitive bank data. Using a simple, Monte Carlo-based credit risk model, this Article illustrates how even basic credit risk modeling—when combined with appropriate bank disclosures—could have significantly enhanced investors’ ability to detect the portfolio risk leading to two of the most severe banking crises in recent history: the collapse of Continental Illinois in 1984 and the near collapse of Citigroup in 2008. Moreover, because such an approach leverages the same aggregate metrics banks themselves use to monitor their risk exposure, the disclosure regime proposed in this Article would impose a minimal disclosure burden on banks while avoiding the need to reveal sensitive position-level data. In the process, the Article demonstrates how using credit risk models to inform bank disclosure policy represents a potentially tractable solution to the challenge of enhancing bank transparency while protecting banks’ proprietary information.