Most of the time when I am debunking an academic paper that says “opacity is good” it is written by someone with a PhD in either Economics or Finance.  It turns out PhDs in Accounting also write academic papers proclaiming opacity is good.  Thereby showing they too don’t understand transparency.  Specifically, that a gap can exist between financial reporting and disclosing the information needed so an investor could know what they own.

John Gallemore, an Assistant Professor of Accounting at the University of Chicago’s Booth School of Business, wrote on “Bank Financial Reporting Opacity and Regulatory Intervention“.  The research question he looked at was

could greater financial transparency force bank regulators to intervene unnecessarily in healthy banks?

No!  But now I am getting ahead of my story.  We need to look at how Professor Gallemore approaches answering the question.

Imagine two banks with loan portfolios identical in all respects. One bank decides to delay fully accounting for expected loan losses, so its provision is relatively small and its profits more robust. The other doesn’t delay and recognizes a larger provision, reducing profits. The first bank’s financial statement will be more opaque, and the second bank’s more transparent (and accurate).

He is right that one bank’s financial statement is more accurate.  However, accurate does not mean either banks’ financial statements make them transparent.

Why not?

The only way anyone could know if two banks have identical loan portfolios is if both banks disclosed their current loans.  While Professor Gallemore has imagined two banks with identical loan portfolios, financial statements do not provide the disclosure necessary so an investor or bank regulator could ever know this.

Confirmation of the inadequacy of financial statement disclosure is provided by bank examiners.  If bank financial statement provided the information necessary so an investor could know the banks had identical loan portfolios there would be no reason for bank examiners to go into a bank.  The reason bank examiners go into a bank is to look at the loan portfolio details so they can try to get their arms around what is going on.

This is a terrific illustration of the gap between financial reporting and disclosing the information investors need so they can know what they own.

Regular readers know the Transparency Label Initiative exists because of this gap.  It identifies investments like bank unsecured debt and equity where financial reporting does not disclose the information an investor needs to know what they own.  The lack of a label acts as a big red flag saying the investment is a blind bet and the investor is likely to lose 100% of their investment.

Professor Gallemore goes on to unintentionally demonstrates why and how bank regulators engage in accounting control fraud.

Accounting control fraud was introduced into the academic literature by George Akerlof and Paul Romer.  They observed stock options gave bank managers an incentive to delay fully accounting for expected losses.  As Professor Gallemore notes, the result of this delay is more robust profits.  Profits that result in a higher stock price and therefore more money to the bank managers as they exercise their stock options.

Please note, accounting control fraud that boosts the stock price can only happen if opacity prevents the investors from seeing management is delaying the accounting for expected losses.  If investors can see losses coming they won’t boost the stock price as a result of the delay.

Professor Gallemore described how regulators use a bank’s opacity for their own version of accounting control fraud.

a more opaque bank that delays recognizing expected loan losses gives regulators the wiggle room to choose not to intervene.

Using a sample of over 7,000 banks, he found

It appears regulators wanted to refrain from interfering with riskier banks during the crisis, particularly when there were other weak banks in the state.

This finding isn’t surprising. The heart of the policy response to the financial crisis was to protect the banks by not making them recognize losses.

By the way, this is not the first time bank regulators have refrained from interfering with insolvent banks and making them take their losses.  In the 1980s, bank regulators did this throughout the Savings & Loans Crisis.  By doing so, they drove up the cost to the taxpayers.

Should bank regulators be given this choice?

No!  Regular readers know the existence of this choice is inconsistent with the design of the financial system.  Banks are suppose to disclose the information investors need to know what they own.  If this were to occur, the choice of delaying recognition of losses on bad assets goes away.  Everyone knows the losses exist so there is no benefit from delaying recognizing the losses.

Please note recognizing the losses doesn’t require regulators intervening unnecessarily in healthy banks.  Recognizing losses is achieved through market discipline.

The fact banks would have to take losses doesn’t trigger public panic or trigger a fire sale of assets.  By design, the combination of deposit insurance and the central bank as a lender of last resort prevents both.