In a new paper, The Leverage Effect of Bank Disclosures, we challenge the widespread view that disclosure requirements prompt banks to reduce their risk and leverage. That view has prevailed since at least 2004, when the Basel Committee introduced Pillar 3 (market discipline) into the Basel II Accord, making disclosure requirements a complement to minimum capital requirements (Pillar 1) and the supervisory review process (Pillar 2) (BIS, 2004). The committee has emphasized that disclosure leads to lower risk and leverage because “the market will require a higher return from funds invested in, or placed with, a bank that is perceived as having more risk” (BIS, 1998, p. 6).
In our paper, we show that the disclosure of bank-specific information such as a bank’s risk exposure or risk assessment processes can actually lead it to increase leverage and risk. Because higher leverage leads to riskier lending practices in our model, we refer to the increase in risk-taking as the “leverage effect” of bank disclosures.
The view that disclosures can mitigate banks’ risk-taking is based on the argument that disclosures make the price of (wholesale) debt more sensitive to banks’ risk-taking decisions. Empirical studies find that the price of subordinated debt is sensitive to information about banks’ risk (Flannery and Bliss, 2019), suggesting that disclosures should reduce informational asymmetries and agency problems between banks and their creditors and force banks to internalize the consequences of their risk-taking decisions. We refer to this channel as the “direct market disciplining effect” of bank disclosures.
We show that this direct effect is only one part of the total effect of disclosures on banks’ risk-taking. The reason is that disclosures, by lowering the agency cost of debt financing, change the cost of debt relative to equity and render debt issuances less expensive for banks. The effect of disclosures on banks’ leverage is typically absent in the standard argument that disclosure requirements reduce risk-taking. However, our paper shows that this leverage channel can be important.
To understand the effect of leverage on banks’ risk-taking, we build on two key characteristics of banks’ capital structure. First, banks finance a considerable part of their balance sheets with insured retail deposits. Since deposit insurance premiums do not (fully) reflect banks’ risk, issuing insured deposits generates a subsidy for banks. Furthermore, as is common in most jurisdictions, insured depositors (the deposit insurance fund) are senior to other creditors and equity owners in case of default or resolution. Second, since the supply of insured deposits is relatively inelastic, many banks also rely on wholesale debt markets to cover their funding needs. We show that banks optimally raise short-term wholesale debt (rather than long-term debt or equity) because it allows them to ratchet up the deposit insurance subsidy. The reason is that short-term wholesale creditors can withdraw their funding quickly when economic conditions deteriorate. By withdrawing short-term debt, creditors leapfrog the priority of insured depositors and dilute their claims. The ability to dilute retail deposits generates a cost advantage of short-term wholesale debt over equity financing even absent other factors that may render equity more expensive than debt (e.g., debt tax shields or implicit bailout guarantees).
In practice, such dilution occurred when wholesale creditors withdrew from U.S. banks in 2008 during the financial crisis. Rose (2015) shows that around 70 percent of the deposits withdrawn from large commercial banks were uninsured even though the majority of their funding came from insured deposits. In addition, recent empirical findings by Chen et al. (2020) highlight that the sensitivity of deposit flows to bank performance is stronger for uninsured deposits, implying that these claims are withdrawn quicker and in larger quantities than insured claims.
In our model, a bank’s optimal funding decision between short-term debt or equity trades off the dilution benefit from issuing short-term debt against the agency cost of debt. Disclosures that lower the agency cost of debt give the bank an incentive to increase its leverage in order to maximize the dilution benefits of debt.
Due to these dilution benefits, the issuance of short-term debt has the same negative effect on a bank’s risk-taking incentives as increasing the amount of insured deposits. The bank, seeking to maximize the value of the put option implied by deposit insurance, therefore monitors less when it issues more wholesale debt, even though disclosures eliminate the agency problem between wholesale debt and equity. This leverage effect counteracts the direct market-disciplining effect of disclosures. Whether the disclosure of information leads the bank to take more or less risk depends on the magnitude of the increase in leverage. We show that, if the increase in leverage is sufficiently large, disclosures lead to greater risk-taking.
Our model has implications for prudential regulation. Banks can only increase their leverage in response to disclosures if their regulatory capital constraint is not binding. Hence, disclosures are more likely to have the desired effect of reducing banks’ risk if capital requirements are sufficiently tight. Alternatively, the negative externality implied by the dilution of insured deposits can be eliminated by taxing short-term wholesale debt. Taxing away the dilution benefits of debt eliminates the cost advantage of debt over equity and reduces banks’ risk-taking incentives. Such a tax can be implemented by requiring banks to pay a deposit insurance premium that increases as their total leverage increases. This result is in line with recent reforms of deposit insurance schemes. For example, the Dodd-Frank Act required the Federal Deposit Insurance Corporation (FDIC) to revise its methodology for calculating risk-based premiums by requiring the FDIC to broaden its definition of the assessment base from domestic deposits to average consolidated total assets minus average tangible equity (FDIC 2020). A consequence of this revision is that the total burden of assessments has shifted from smaller banks to larger banks that rely more on short-term wholesale funding (Kreicher et al. 2014).
BIS. 1998. Enhancing bank transparency. Bank for International Settlements / Basel Committee on Banking Supervision.
BIS. 2004. International Convergence of Capital Measurement and Capital Standards. A Revised Framework. Bank for International Settlements / Basel Committee on Banking Supervision.
Chen, Q., I. Goldstein, Z. Huang, R. Vashishtha. 2020. Liquidity transformation and fragility in the US banking sector, NBER Working Paper 27815, National Bureau of Economic Research.
FDIC. 2020. A History of Risk-Based Premiums at the FDIC. Federal Deposit Insurance Corporation.
Flannery, M., R. Bliss. 2019. Market discipline in regulation: Pre and post crisis. In A. N.
Berger, P. Molyneux, J. S. Wilson (Eds.). The Oxford Handbook of Banking. Oxford University Press. pp. 339 – 356.
Koenig, P. J., C. Laux, D. Pothier. 2021. The leverage effect of bank disclosures. Discussion Paper 31 / 2021. Deutsche Bundesbank.
Kreicher, L., R. McCauley, P. McGuire. 2014. The 2011 FDIC assessment on banks’ managed liabilities: interest rate and balance-sheet responses. In R. de Mooij, G. Nicodème (Eds.). Taxation and Regulation of the Financial Sector. MIT Press. Ch. 15.
Rose, J. N. 2015. Old-fashioned deposit runs. Working Paper 2015 / 111. Board of Governors of the Federal Reserve System.
This post comes to us from Philipp J. König at Deutsche Bundesbank, Christian Laux at the Vienna University of Economics and Business and Vienna Graduate School of Finance, and David Pothier at the University of Vienna and Vienna Graduate School of Finance. It is based on their recent paper, “The Leverage Effect of Bank Disclosures,” available here. The views expressed herein are those of the authors and do not necessarily represent those of the Deutsche Bundesbank or the Eurosystem.