Transparency in the Financial System: Rollover Risk and Crises

• Date: 01 August 2015
• Author: MATTHIEU BOUVARD,ADOLFO DE MOTTA,PIERRE CHAIGNEAU
• DOI: http://doi.org/10.1111/jofi.12270
• Published date: 01 August 2015

THE JOURNAL OF FINANCE •VOL. LXX, NO. 4 •AUGUST 2015

Transparency in the Financial System: Rollover

Risk and Crises

MATTHIEU BOUVARD, PIERRE CHAIGNEAU, and ADOLFO DE MOTTA∗

ABSTRACT

We present a theory of optimal transparency when banks are exposed to rollover risk.

Disclosing bank-specific information enhances the stability of the financial system

during crises, but has a destabilizing effect in normal economic times. Thus, the reg-

ulator optimally increases transparency during crises. Under this policy, however,

information disclosure signals a deterioration of economic fundamentals, which gives

the regulator ex post incentives to withhold information. This commitment problem

precludes a disclosure policy that provides ex ante optimal insurance against aggre-

gate shocks, and can result in excess opacity that increases the likelihood of a systemic

crisis.

FINANCIAL CRISES ARE OFTEN associated with demands for an increase in the

transparency of the financial system. Following the 2008 financial crisis, reg-

ulators have periodically performed and disclosed stress tests on the largest

financial institutions. This practice has been the subject of much debate, how-

ever. For instance, Fed Chairman Ben Bernanke cautioned that “when the

stress assessment was getting started, some observers had warned that the

assessment and, in particular, the public disclosure of the results might back-

fire.”1Moreover, the accuracy and informativeness of these tests have been

questioned, emphasizing the credibility issues that regulators face when ad-

justing their disclosure policy. In this paper we develop a model in which the

optimal level of transparency is contingent on the state of the financial sys-

tem, and show that the regulator faces a commitment problem when trying to

implement the optimal transparency policy.

∗Bouvard and de Motta are at McGill University, Desautels Faculty of Management, and

Chaigneau is at HEC Montreal. We thank the Editor, Kenneth Singleton, the Associate Editor,

and two anonymous referees. We are grateful to Sudipto Bhattacharya, Valentin Haddad, Au-

gustin Landier, Fr´

ed´

eric Malherbe, Guillaume Plantin, Viktors Stebunovs, as well as audiences at

the University of Geneva, Toulouse School of Economics, HEC Paris, Chicago Booth, McGill Uni-

versity, Banque de France, the 2012 European Meeting of the Econometric Society in Malaga, the

1st Oxford Financial Intermediation Theory Conference, the McGill-Todai Market Frictions Con-

ference in Tokyo, and the 2012 AFFI international finance meeting in Paris. Matthieu Bouvard

acknowledges financial support from the French National Research Agency (Project “Regulation

and information sharing”); Adolfo de Motta acknowledges financial support from Institut de Fi-

nance Math´

ematique de Montreal. All errors remain our own.

1Speech at the Federal Reserve Bank of Chicago, Illinois, on May 6, 2010.

DOI: 10.1111/jofi.12270

1805

1806 The Journal of Finance R

We consider a stylized model of financial intermediation with rollover risk, in

which financial institutions—banks—have exclusive access to a long-term in-

vestment technology that is illiquid. Banks are ex ante identical but they differ

ex post in the quality of their investment technology and hence in the quality of

their balance sheets. Furthermore, the quality of banks in the financial system

is affected by aggregate shocks. While investors may have information about

these shocks, and therefore about the ex post average quality of banks, they

do not observe the idiosyncratic component of each bank’s balance sheet. By

contrast, the regulator has access to this bank-specific information and can

choose to communicate it to the public.

In the baseline case in which investors observe aggregate shocks and there-

fore know the average quality of banks in the financial system, the optimal

disclosure policy depends on the realization of these shocks. When the average

quality is high enough that investors are willing to roll over their credit, it is

optimal not to disclose bank-specific information as transparency may expose

lower-quality banks to a run. In contrast, when a negative shock pushes the

average quality below a threshold, the regulator switches to transparency, that

is, discloses the idiosyncratic component of each bank’s balance sheet. Oth-

erwise, if investors knew that the average quality was low but could not tell

which banks were of higher relative quality, there would be a run on the entire

system.2This result relies on the properties of the bank run equilibrium, in

which the mass of withdrawals is a nonlinear function of a bank’s expected re-

turn. Specifically, under good economic conditions, pooling the most profitable

banks with a few lower-quality banks has little effect on the rollover risk of the

former, while it significantly reduces the probability of runs on the latter.

We turn next to the leading case in which the regulator also has private infor-

mation about aggregate shocks to the financial system. In this case, provided

that investors receive sufficiently precise yet imperfect information about ag-

gregate shocks, the equilibrium disclosure policy is still such that the regulator

discloses bank-specific information when the average bank quality falls below

a threshold. There is an important economic difference, however: when the

regulator has private information about aggregate shocks, investors perceive

the absence of information disclosure as a positive signal about the state of the

financial system, that is, no news—opacity—conveys good news. This signaling

aspect of the disclosure policy, which gives the regulator incentives to withhold

information, generates a commitment problem. Specifically, the regulator’s ex

post disclosure decision does not internalize that extending the opacity region

to worse realizations of the aggregate shock makes investors more likely to run

under opacity.As a result, the regulator keeps the system opaque in more states

2Recent empirical evidence supports the view that stress tests provided useful information to

market participants during the recent crises, despite the credibility issues that we discuss below.

See, for instance, Peristiani, Morgan, and Savino (2010), Bayazitova and Shivdanasi (2012), Ellahie

(2012), and Greenlaw et al. (2012).

Transparency in the Financial System 1807

than is ex ante optimal, which creates instability by increasing the likelihood

of a systemic run.3

We also consider the case in which the precision of investors’ information

about aggregate shocks is arbitrarily low, which widens the informational ad-

vantage of the regulator. The presence of a large informational asymmetry re-

inforces the signaling role of the regulator’s disclosure choice and exacerbates

the commitment problem. In particular, the regulator may lose the ability to

implement a state-contingent disclosure policy that provides insurance against

shocks to the financial system.

Finally, we study the case in which the regulator can credibly disclose aggre-

gate information without disclosing bank-specific information. The regulator’s

private information about aggregate shocks then tends to unravel, which high-

lights the fundamentally different economic principles that lead to the disclo-

sure of aggregate and bank-specific information. In equilibrium, transparency

still increases as fundamentals deteriorate, but there is now a gradation in the

release of information: the regulator discloses aggregate information without

bank-specific information after a moderate aggregate shock, and discloses both

aggregate and bank-specific information after a large negative shock.4

This paper builds on seminal models by Bryant (1980) and Diamond and

Dybvig (1983) in which strategic complementarities between depositors may

trigger runs and lead to the early liquidation of solvent but illiquid banks. Be-

cause these models typically have several equilibria, which makes the impact

of public policies difficult to assess, we use the global games approach (Carlsson

and van Damme (1993), Morris and Shin (1998), Morris and Shin (2003)) to ob-

tain equilibrium uniqueness. Our paper is therefore related to Morris and Shin

(2000) and Goldstein and Pauzner (2005), who use global games techniques to

refine models of bank runs. Within this literature, we introduce heterogene-

ity among banks, which makes the release of bank-specific information by the

regulator a relevant issue.5

Our paper belongs to the literature on transparency in the banking sys-

tem. (See Landier and Thesmar (2011) and Goldstein and Sapra (2014)fora

review of the trade-offs related to transparency in financial systems.) A com-

mon theme in this literature is that transparency allows investors to better

3This commitment problem is consistent with the concerns raised about the leniency of some

of the stress tests. For instance, while all banks had passed the 2010 stress test performed by

the Committee of European Banking Supervisors, the 2011 stress tests conducted on Irish banks

(largely by outside independent advisors) revealed a total capital need of 24 billion. See Schuer-

mann (2013).

4This prediction is consistent with the evolution of stress test disclosures in the United States

between 2009 and 2011 (Schuermann (2013)).

5See also Morris and Shin (2004), Morris and Shin (2009) for models of rollover risk using global

games. Eisenbach (2013) also introduces heterogeneity among financial institutions and studies the

optimality of short-term debt in the presence of aggregate risk. Plantin (2009) studies bond pricing

when investors’ concerns about secondary market liquidity create strategic complementarities

among them. Chen, Goldstein, and Jiang (2010) and Hertzberg, Liberti, and Paravisini (2011)

provide empirical evidence consistent with the existence of strategic complementarities between

investors in financial institutions.