How Bank Regulation and Supervision Can Weaken Financial Stability

We argue that bank regulation and supervision interfere with pricing risk by creating opacity. Given that market disclosures enhance the efforts of supervisors, and vice versa, more disclosure could enhance financial stability (see Spatt, 2010)[1]. In addition, we believe that disclosure would provide information on the competence and performance of regulators and supervisors (reducing adverse selection about regulators) and increase their incentives (reducing moral hazard). This would make capital markets more effective in addressing future banking problems and reducing reliance on bank regulators who have arguably failed the public. We question the value of withholding vast amounts of banks’ privileged information and argue that, although this unique regulatory practice has a long history, it is not ethical in the context of fair treatment of investors in public entities. Indeed, firms are required under the securities laws to disclose material nonpublic information, at least when they raise capital.

Given periodic banking crises in the U.S., the traditional approach to bank regulation and supervision — and proposed reforms — warrant skepticism, prompting questions about the effectiveness of these approaches in providing robust financial stability. Consider capital reform. One estimate is that a 1 percent increase in capital produces a loss of about 4.2 basis points of long-term GDP due to higher loan rates and reduced lending (Firestone, Lorenc, and Ranish, 2019)[2]. To be sure, this loss should be compared with the benefit of a higher capital ratio. But that is not the point. Regulators and supervisors are entrusted with establishing a safe banking sector, but they have failed. In the process, they have imposed a large cost on the public for a situation that they managed inadequately. Again, this is not a critique of a higher equity capital, rather a call for reform of regulation and supervision, a critical topic concerning the governance of the Federal Reserve System.

Another example would reinforce this point. Concentration in banking has been increasing over time (see (Ma, 2022)[3] and Baron, Schularick, and Zimmermann, 2023)[4]). A contributing factor has been the expectation and demand of regulators during a crisis that the larger or healthier banks acquire the assets of the weaker or failing banks to save the banking system (see Tahyar, 2018, page 28 on Henry Paulson pressuring the BoA to acquire Merrill Lynch)[5]. (Acquirers often receive government assistance in one form or another.)  Just look at the increase in the assets of the top five commercial banks following the financial crisis.

Similarly, one can examine the assets of large commercial banks following the regional bank crisis from Q4 2022 to Q3 2023. Industry concentration has costs. Some evidence exists outside banking. For example, tax avoidance increases with concentration (Glovera and Levine, 2023)[6]. Also, costs can be passed to consumers (Bräuning, Fillat, and Joaquim, 2022)[7]. The costs can potentially be measured relative to GDP, although we are not familiar with estimates using U.S. data. The point is that, if the cost of banking concentration (relative to its benefits) is large, and since the failure of supervision and regulation contributes to the costs, then it is prudent to consider alternatives to current supervisory practices. This is aside from the costs associated with too-big-to-fail (TBTF).

Supervision through disclosure and reliance on market forces as mechanisms for stability will likely enhance the health of the banking system and reduce the direct and indirect costs of failures. Where the Federal Reserve System seems to have limited accountability, disclosure helps protect the public. For example, in the SVB case, if much more had been known earlier about the bank positions, uninsured deposits, etc., outsiders might have assessed the risks and raised alarms that regulators were not recognizing.

Disclosure should aim to communicate regulators’ assessment and concerns to stakeholders about bank governance and operations. Banks’ conduct and industry dynamics are influenced by bank regulators who oversee banks’ assets and can affect information flow. Information is central to capital markets’ assessment of banks and, thus, their valuations. However, U.S. regulators rarely disclose bank information beyond the publicly available, mandated quarterly financial reporting to regulators and annual stress tests (see Sherrill Shaffer (1995)[8], Prescott (2008)[9], Bergin and Stiroh (2022)[10], and Tahyar (2018)). Exceptions are enforcement actions covering violations of laws or rules.

U.S. bank regulators argue that controlling or suppressing negative information is often necessary to avoid upsetting the market and causing bank runs.[11]  Yet the argument is weak. Early disclosure improves bank governance and forces management to enhance the health of the bank to preempt disclosure by regulators — just as firms try to implement policies that enable them to pass stress tests.

Except in required financial reports, banks are not likely to disclose negative information about their prospects as they might lose their discretion due to regulatory scrutiny (Mehran, 2022)[12]. Yet, if they do not disclose and something goes wrong, they might face litigation (see NYCB for a recent shareholder suit claiming that the bank failed to disclose material information about its real estate losses)[13]. While scrutiny by regulators is certain, litigation is not. This suggests that voluntary disclosure of negative information is likely to be too late if a management team wants to avoid scrutiny by regulators and supervisors.

The current regulatory practice suggests that supervisors should attempt to address banking problems privately. However, what problems regulators can deal with privately and effectively (independent of the market) are unclear. As noted by Michael Barr, vice chair for supervision of the Federal Reserve, after the failure of Silicon Valley Bank (SVB) and closing of Signature Bank, regulators had concerns about SVB, but viewed their role as not to manage the bank. While disclosure after SVB’s revealed these concerns, regulators’ failure to act remains puzzling. What is more, failing to share concerns early on precludes the market from offering solutions that could complement regulatory efforts.

If regulators opt for some disclosure, its timing becomes crucial to financial stability. Given the concern about bank runs and fear of harming confidence in regulators’ oversight, the release of any negative information would be delayed, just as in the past. If disclosure is deferred, or if the market learns about regulators’ inability or willingness to manage a problem, then the negative impact on the bank and its security prices will likely be far greater. By then, the market may not have time to help save the bank or the industry, protect regulators’ reputation, and reduce direct losses to investors and indirect costs to the U.S. Furthermore, regulators’ delayed disclosure is more likely to generate contagion. The perception that supervisors have allowed problems to develop could lead to the justifiable conclusion that other banks could soon be in trouble as well.

Any direct learning by the market could be seen as extremely damaging to the bank and the industry. This is true regardless of regulators’ awareness of any material information that they knew but did not disclose. In addition, the public perception of regulators’ ability to manage bank problems quickly and privately would be adversely impacted. The market would infer that the resolution of the problems may take time and be very costly. The unwillingness of supervisors to tackle bank weakness beforehand undercuts both the valuation of banks and the effectiveness of supervision.

That regulators could address banking problems on their own once the market learns about them is a false premise. Following the financial crisis and the 2023 banking crisis, regulators need the help of banks to save the banking system just as they did during the 2023 banking crisis. Timely disclosure about banking problems suggests that concerns can be addressed beforehand when a bank is still a going concern. Delay undercuts the ability of the banking regulator or insurer to protect its financial interest and can result in significant losses for the regulators. Again, SVB is a good illustration.

Also consider U.S. regulators’ concerns with Deutsche Bank in December 2013.[14] The bank’s rejection of U.S. regulators’ recommendations to improve its capital was disclosed in the press on July 22, 2014, more than six months after revelation of a whistleblower’s concern. Following the announcement, Deutsche Bank’s share price dropped 3 percent. Deutsche Bank raised $11.5 billion in equity in July 2014. According to two senior bank employees, the attempt by the bank whistleblower to alert investors prompted an equity offering, illustrating how effective disclosure by an insider can be when regulators fall short.

By contrast, consider Fed Vice Chair Michael Barr’s testimony on March 28, 2023, regarding SVB. He stated that regulators were aware of the bank’s problems as early as December 2021 and gave multiple warnings to bank management throughout 2022. Yet, the market learned about SVB’s health just days before the bank’s collapse. No bank insider or regulator raised a red flag publicly. Furthermore, according to lawmakers at the hearing, regulators did not exercise their duty under the law to force the bank to take corrective actions. While Deutsche Bank and SVB are different in many respects, stakeholders in Deutsche Bank benefited from disclosure by an insider. Thus, the market, and its ability to price asset risk of financial institutions more effectively, benefit from disclosure by regulators.

Opacity, that is, differences in regulators’ assessment of a bank’s health and conduct relative to that of the market, is large in normal times due to the informational advantage of regulators. Yet regulators’ private information and thus risk is undisclosed and not priced (see Partnoy and Eisinger, 2013)[15]. Behavioral bias can also exacerbate the problem. For example, with limited investor attention, investors may neglect information that is not disclosed, particularly when there has not been a banking problem for a while (Hirshleifer and Teoh, 2003)[16].

Flannery, Kwan and Nimalendran (2001) use bid-ask spreads and price impact of trades as a proxy for opacity and document that large banks exhibit similar behavior as nonfinancial firms of comparable size.[17] But we learned in the SVB example that there were many weaknesses in the bank’s operation for at least 18 months before its collapse, but they were not priced (for assessment of risk before and after SVB crisis see Fischl-Lanzoni, Hiti, Kaplan, and Sarkar (2024)[18]. This suggests that it is difficult to assess banking firms’ opacity by comparing them to nonfinancial firms. The informational advantage of regulators relative to the market dissipates at the time of crisis, as in the SVB case. Also, the informational advantage in effect becomes irrelevant. This is particularly true as banks lose value very rapidly.

It should be noted that analysts have fewer incentives to produce information when the industry is performing poorly because they anticipate regulatory intervention (see Armstrong, Guay, Mehran, and Weber 2016)[19]. Given the opacity in normal times, and rapid asset sales in crisis times, the actual value of bank assets is not known because risk is not priced effectively. Thus, bank opacity is not solely driven by the nature of bank assets but is also influenced by banking regulation and the way that regulation and supervision are enforced. Inefficient information flows clearly impede accurate determination of risk and related pricing. SVB was much riskier than generally perceived, and given trust in its regulator, the public and their proxies, i.e., lawmakers, did not seek any information.

Not surprisingly, as in the SVB case, a quick reassessment of asset valuation in the market occurs in the wake of a revelation of critical news about a bank or an industry’s financial condition. Typical value reassessment often produces losses in the market of tens of billions of dollars for the industry. The losses in equity valuation are triggered by the revelation of the bank’s financial loss as well as by the anticipation of closer supervision and thus less discretion at each bank. Further, an update on the health of the industry and new sentiment about regulators’ competence to manage the industry might contribute to losses.

Delay in releasing timely information also generates other problems. It prevents the market from adjusting to bad news and weakens bank governance. Timely disclosure would help shareholders exert pressure on bank management and bank policies in normal times. Rare shareholder activism in the banking industry is partly driven by uncertainty about bank valuation as a result of the opacity created by regulation and supervision (see Adams and Mehran, 2003)[20]. Thus, the timely disclosure of critical information can affect activism and a bank’s cost of capital.

One can argue that suppression of information by bank regulators is unethical. Investors invest in assets of banks based on obfuscated information about bank asset quality as well as management quality (see Partnoy and Eisinger, for an example). Opacity is unlikely to be corrected by pressures from investors or class action lawsuits. The U.S. Securities and Exchange Commission typically sues companies when they sell securities and hide information. But banks may be allowed to raise capital while their regulators know more about their potentially unhealthy conditions than investors. Regulators in effect act like underwriters who support prices in equity offerings.

This raises several issues. First, the regulators may be misleading the public by encouraging the purchase of overpriced assets and false corporate disclosures. Second, banks have an incentive not to disclose information voluntarily, particularly in troubled times, as noted earlier. Thus, management’s concealment of information would make discovery of problems harder for supervisors. Third, the assumption that regulators address problems efficiently may not be true. The problem is that the public rarely has information to assess regulators’ effectiveness in normal times to demand accountability. In crisis times, more disclosure is required as a result of government intervention and support.

While we contend that more disclosure by regulators will have substantial benefits than current practices, we do not have a position on all of the details concerning what should be disclosed. We anticipate that, just as with many regulations, fine tuning a novel approach would take time. A prudent approach would start with discussions involving industry participants and academics. Regulators cannot realistically produce a stable banking environment in a fast-changing world without the help of the market. As in the past, they will opt for capital reform as an example in the next crisis. Our question to regulators is what would they do differently if they were to be held accountable in a future crisis? Early disclosure of negative information by regulators might help banks manage their assets and control their exposure more effectively.

In fact, regulators may have already started to disclose more about banks. Tahyar (2018) provides examples of leaks of confidential supervisory information by regulators. More recently, there were leaks about a list of supervisory topics for seven regional banks.[21] The leaks were effectively like a stress test, asking some regional banks, not subject to stress test requirements, to address a few supervisory concerns. While we have not examined if credit and equity prices of the banks that were subject to the leaks suffered in the announcement, there was no run on those banks or disturbance in the market. This supports the idea that orderly disclosures by regulators beyond the mandated disclosure could promote stability in the banking industry.

A few points should be noted. The first is whether disclosure by regulators is needed in a world with stress tests. Of course, much can go wrong with stress tests; unfamiliar problems may surface shortly after a test is conducted, for example. Furthermore, it is uncertain that regulators interpret financial information accurately. Differences of opinion may occur.[22] Thus, disclosure can help the market to reassess its prior on bank risk, and that is likely to benefit regulators as well. Also, as noted earlier, disclosure could alone improve bank governance.

The second point concerns deposit insurance. We argue that regulators should make public problems at banks so as to elicit corrective discipline before the problems become so big that they threaten financial stability. One might interpret this as implying that the regulators could credibly and publicly say that deposits would not be protected in the event of a failure. This is incorrect. Deposits will be covered as before.

The third point is that our discussion is not about disclosure during a crisis, but rather disclosure during normal times to mitigate crises. What should be disclosed during a crisis, if anything, is beyond the scope of this post. In fact, the practice has been to provide near full protection for the banking industry during a crisis. In that setting, disclosure serves no purpose (as in the 1933 declaration of bank holiday).

It is clear that some increased levels of disclosure are likely to improve financial stability. Indeed, we believe that better disclosure by regulators could have mitigated the 2023 crisis. Advocating for no disclosure in the presence of regulatory failures amounts to accepting more financial crises. The costs of opacity should be balanced against the benefits of some disclosure by regulators. We encourage researchers to examine features of this trade-off. Finally, our proposal has implications for policy decisions drawing on securities prices, such as those by FSOC. Policies could fail not because they are bad, but rather because of reliance on distorted credit and equity prices induced by opacity triggered by supervision and regulation.
























This post comes to us from Hamid Mehran, a financial economist, and Chester Spatt, Pamela R., and Kenneth B. Dunn Professor of Finance at Carnegie Mellon’s Tepper School of Business.

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