How Does The Market Digest The Transparency Shock?VW Staff
Full Disclosure And Financial Stability: How Does The Market Digest The Transparency Shock?
LIUC – Universita Cattaneo
LIUC Universita Cattaneo
LIUC Universita Cattaneo
May 2, 2016
Since macro-prudential stress tests have become the main instruments of the supervisory authorities toolkit, the debate on the effect of their results disclosure inflamed. Our work aims at providing a framework that, via a dynamic estimation of the betas, allows to observe the impact of the new information flow on the stability of the banking system. What we find is that, contrary to literature wisdom, almost all banks betas decrease, as the transparency shock contributes to an overall systemic risk drop.
Full Disclosure And Financial Stability: How Does The Market Digest The Transparency Shock? – Introduction
The 2008 financial crisis can be described as a large-scale modern bank run. As the literature tells us, the trigger of such runs is the public uncertainty about the solvency ability of banks, id est a lack of overall transparency which causes panic in agents who withdraw their money from financial institutions vaults (Diamond and Dybvig, 1983). The modern version of this narrative sees banks investors and even insiders, unable to assess the quality of banks portfolios, the extension of their exposure to the so-called “toxic” assets and their solvency. This brought banks stocks to trade at rates that were overly discounted and even the interbank market froze as banks were not able to evaluate their peers conditions any longer. As Flannery et al. (2013) argue, behind this mechanism there was a dramatic increase in the information asymmetry of the financial system. Public authorities promptly sought to tackle this problem but soon realized that they did not have at their disposal an efficient crisis management tool which could allow them to curb the panic and restore confidence.
In such a distressed environment, regulators had to concentrate their efforts in reassuring the market about the solvency ability of the single banks, and on their resilience to possible further turmoil. The first to act was the Federal Reserve Bank that, in early 2009, designed and ran an unprecedented supervisory exercise, the Supervisory Capital Assessment Program (SCAP henceforth), with the declared aim to ensure adequate capital to promote lending and restore investor confidence (Hirtle et al., 2009). The valuable information contribution of the SCAP has been recently tested empirically, among others, by Morgan et al. (2014) and Neretina et al. (2014) proving that this exercise can convey significant new data to the market which in turn improves its ability to evaluate banks assets and solvency. Many commentators have attributed this success to the choice of fully disclose the results by communicating to the market all the bank specific findings. This decision has been highly debated in the academic world as there are doubts about the public reaction to the disclosure of such critical information. Goldstein and Sapra (2013) claim that, in a crisis situation, disclosure has indeed beneficial effects but, since financial markets are featured by strategic environments, agents may give excessive weight to public reactions, disregarding fundamentals.
If so happens, market price information content is bound to decrease and hence market discipline is harmed. Following this line, the main concern on a full disclosure stems from the fear that, contrary to conventional wisdom, it can add further pressure to already distressed institutions (Spargoli, 2013; Cordella and Yeyati, 1998). Banks, forced to adequate capital to the risk exposure, can be compelled to downsize as bad news about their capital provision may cause the exclusion from the funding market. If such an outcome occurrs, stress tests would completely fall short of expectations as the policy purpose behind their implementation is to revive the funding market and ease banks access to fresh capital injections. Hence, stress tests may have a considerable announcement effect changing the expectations of agents on the supervisory stance (as proved for the European Comprehensive Assessment by Lazzari et al. (2016)). In light of this, it has become crucial to assess how markets risk perception would change in the event of such a disclosure, in order to make authorities able to implement a results communication policy that best addresses the task of stabilizing the banking system by restoring confidence in it when needed.
The key question then is: how does the market digest a transparency shock? Moreover, how does public risk perception change according to the single banks performance in this kind of exercises? Our paper aims at empirically assessing how the public updates its risk assessment of banks, following the disclosure of stress tests results. In particular, we want to understand what the market infers on the riskiness of each single institution, primarily about the ones who end up to be undercapitalized. The estimation of market reactions is not a trivial exercise: indeed it requires a model that is able to estimate time varying parameters and to adopt an algorithm that recursively learns from the improved information set. Doing so, we are able to infer if, when and how the market updated its risk perception in the presence of new information without the need of a priori assumptions. Among the many statistical specifications which are able to tackle such issues (Das and Ghoshal, 2010), we have decided to apply a non-Gaussian state space representation of a Fama-French three factors model estimated (henceforth 3FM) with a Kalman Filter as we believe it can face the trade-off between simplicity and mis-specifications avoidance. The market beta will be our proxy for the public risk perception of each banks securities.
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