I examine the effect of transparency on risk-taking in the banking industry. In highly leveraged firms such as banks, stockholders have incentives to increase risk at the expense of debtholders. However, managers' risk aversion, arising from the desire to protect their careers and their private benefits of control, acts as a natural constraint on risk-taking. Transparent disclosure standards can improve stockholders' ability to monitor managers and align managerial actions closer to stockholders' interests. However, transparent disclosure standards can also improve debtholders' ability to monitor and constrain risk-taking (i.e. generate 'market discipline' from debtholders).
Examining these competing forces in a cross-country setting, I find that transparent disclosure standards are associated with increased risk-taking behaviour. This is consistent with disclosure improving stockholders' ability to monitor managerial insiders. However, in partition tests, I find that the effect of greater disclosure depends crucially on the underlying institutional environment in the country. While disclosure does generate greater market discipline, the market discipline effect of disclosure is significantly diluted by the presence of generous and explicit deposit insurance guarantees, which reduce debtholders' incentives to monitor bank risk-taking. Furthermore, in countries with strong protection of stockholders' rights and substantial use of equity-based compensation (where managerial risk-taking is expected to be already high) increasing disclosure restrains risk-taking, consistent with disclosure generating more effective market discipline from debtholders. On the other hand, in countries with strong protection of creditors' rights and low equity-based compensation (where managerial risk-taking may be sub-optimally low) increasing disclosure results in greater risk-taking behaviour, consistent with disclosure generating greater monitoring from stockholders.
This evidence has implications for bank regulators, who are advocating improved bank transparency with the objective of constraining excessive risk-taking by banks. In particular, the results shed light on where stronger disclosure requirements may be more effective in generating market discipline and constraining bank risk-taking.