Stumbled across an article by two professors from HEC Lausanne who found the discipline on banks that resulted from greater disclosure resulted in less risk taking.

Recent research by Professors Pierret and Steri highlights the role of regulatory monitoring through stress tests (like the CCAR) in reducing the incentives of banks to take risks when banks are subject to higher capital requirements. In their paper  «Stressed Banks», they show the contrasting effect of stress tests on banks’ risk taking.

On one hand, stress tests increase bank capital requirements requiring banks to finance themselves with more equity. On average, banks subject to the CCAR face more stringent capital requirements than other banks, namely 6.8% versus 3% of assets. Higher capital requirements increase the cost of funding of banks when equity is costlier than debt. Banks facing higher costs could rationally respond by shifting their portfolio towards more profitable hence risky assets. On the other hand, the authors show that stress tests can dampen the risk-taking channel from higher capital requirements through a more detailed monitoring of the riskiness of banks’ assets.

They find that banks examined by the Federal Reserve in the CCAR are more prudent than other banks, after controlling for the former’s response to the more stringent capital requirements they face.

Their results suggest that higher capital requirements are not a substitute for regulatory monitoring, but actually need to be accompanied by additional monitoring of banks’ asset risk…

If once per year stress tests result in less risk taking by banks, just imagine how much less risk taking banks would engage in if they had to disclose their current exposure details.  With this data, the market could conduct stress tests on the banks on a daily basis.