Stress Tests: When Is Full Disclosure Too Much Information?

If you’re in a romantic relationship, you’ve probably learned that being open and transparent can lead to some unintended — and potentially unpleasant — consequences. Transparency is an equally complicated ideal for financial market regulators.

Since the financial crisis was triggered in 2008, regulators have been under pressure to take regular readings of major financial institutions via controversial stress tests, and to report areas of risk to investors and the public. There is evidence that stress tests provide useful information to market participants during economic downturns, though many contend that they can be gamed and are unreliable.

Beyond the efficacy of stress tests, however, there are inherent risks in pursuing an open disclosure policy that reveals the risk exposure of specific institutions rather than the financial system as a whole. For one, a liberal approach to transparency can destroy risk-sharing opportunities. In the interests of stability, says Pierre Chaigneau, an assistant professor at Smith School of Business, financial institutions spread risk among themselves — say, hedge their exposure to currency fluctuations — something they would be reluctant to do if they knew the other institution was in financial distress.

“It's easy to understand in the context of insurance,” says Chaigneau. “If it were common knowledge that you would be ill next year or that your house would burn down, you wouldn’t be able to get health insurance or fire insurance. These insurance opportunities would be destroyed precisely because of too much information. The same logic would apply to the financial system.”

Another potential cost of transparency in times of an economic shock, he says, is that it could trigger a run on a bank that may be fundamentally solvent but temporarily illiquid. If depositors and investors become spooked, that could be bad news for the strong banks as well as the weak.

No News Is Good News

This scenario is at the heart of a study conducted by Chaigneau and colleagues Matthieu Bouvard and Adolfo de Motta, both of McGill University. They created a model that tried to determine the optimal transparency regulators should provide about specific banks. They focused on the scenario of banks that were solvent yet carrying a large amount of short-term debt that made them vulnerable to rollover risks. What they concluded is that, in trying to do what’s best for the financial system and investors, regulators are caught in a catch-22.

Ideally, Chaigneau says, regulators calibrate their level of transparency depending on the state of the economy. In good economic times, creditors and depositors may not be very well informed about the health of each financial institution, but they would know that banks and other financial institutions are, on average, healthy and unlikely to fail. In that case, it is beneficial for the regulator to hold back specific information about the state of each financial institution so as not to trigger a run on weaker institutions.      

But when the financial system is under duress, that’s when the regulator should step in and disclose bank-by-bank information. “When the macroeconomic conditions are sufficiently bad, the goal of disclosing information is to avoid a systemic crisis,” says Chaigneau. “You just reveal to everyone which ones are the good banks and which are the bad.”

And that’s just what their modelling indicated: when banks are exposed to rollover risk, the disclosure of bank-specific information following a shock to the economy does indeed increase the stability of the financial system.

Commitment Problem

There’s one problem: because regulators are known to have inside information, their every move and non-move is a signal to investors and the public. Keeping information close to their chest is viewed as good news while revealing the at-risk performers makes them look as if they were running scared and fearing contagion. As a result, they have an incentive to postpone the more transparent reporting for as long as possible.

“It relies on the regulator's ability to commit to being opaque only up to a point,” says Chaigneau. “That’s pretty hard to achieve.”

How can the regulator’s commitment problem be solved? Chaigneau says there was a similar debate in the early 1980s about central banks committing to a policy of low inflation. The reasoning was that central banks would always like to announce a low inflation policy; that’s what consumers and most firms want to hear. But, when things don’t go their way, they would be tempted to lower interest rates to achieve higher growth and lower unemployment. That, of course, would result in higher inflation, so their announcements were hardly credible.                 

The commitment challenge for central banks was solved by making them independent of political pressures. “That enabled them to be able to commit and, indeed, during the last few decades, inflation has been moderate,” says Chaigneau. “This could be a way to ensure that regulators are able to commit” to a consistent disclosure policy.

Chaigneau says that when financial market regulators disclose bank-specific information, it implies that pressure is being placed on the weakest financial institutions in order to release pressure from the fittest ones. Such disclosure should be just a first step to settle the market. “This suggests that, following information disclosure, the regulator should be ready to intervene,” either with a credible private capital-raising program or with an adequate government assurances to allay creditor concerns.

— Alan Morantz