In banking, disclosure promotes stability

More bank regulation results in fewer bank failures, research suggests

By Robin Mordfin     
July 01, 2013

From: Magazine

The recent financial crises in Europe, Asia, and the United States have revived interest in understanding how disclosure regulations affect the stability and development of banking systems. Supporters of public disclosure argue it exerts discipline on banking institutions and gives them incentives to avoid risk. Opponents fear it could trigger bank runs.

Because current banking regulation makes it difficult to separate the effects of disclosure from other characteristics of banking systems, João Granja, a PhD candidate at Booth, is using historical data from the National Banking Era (the late 19th century through to the creation of the Federal Reserve System in 1914) to consider the issue. Granja concludes that reporting requirements advanced the stability and development of banking systems during that period—and could resonate with what we see today.

Three different banking systems operated concurrently in the United States in the late 19th and early 20th centuries. There was some federal regulation, but it only applied to banks that opted to be federally regulated. State banks operated under charters granted by state banking authorities, and some states adopted reporting requirements more than half a century later than others.

This patchwork of authority allows Granja to compare the effects of the various regulations. For his purposes, the federally regulated banks serve as a benchmark for the effects of regulation, and he can track the effect of regulations as they were rolled out in individual states.

Granja notes that when bank regulation went into effect, the rate of bank failures declined. Depositors apparently developed more trust in the banks, and increased their rate of long-term deposits relative to short-term ones. The capital ratios of banks, which can be thought of as the buffers that bankers offer to depositors against losses in the asset portfolio, fell after the disclosure regulation, suggesting that depositors needed less assurances to trust their money to commercial banks.

Granja notes that disclosure regulation can be detrimental to financial stability, as imprecise data can unduly exacerbate depositors' fears and lead to bank runs. Still, the fact that mandatory reporting requirements led to fewer bank failures indicates that disclosure was a valuable tool during the National Banking Era. Whether it applies to modern, complex financial systems is another question. 

João Granja, "Disclosure Regulation in the Commercial Banking Industry: Lessons from the National Banking Era," PhD diss., University of Chicago Booth School of Business, 2013.