Economists at the World Bank looked at the question of “can bank capital substitute for oversight and supervision”.  As part of their analysis, they looked at the availability of information on the banks to the financial markets.  They found the better the disclosure the less capital and related regulatory oversight was needed to reduce systemic fragility.

I always like it when Economists discover the combination of transparency and caveat emptor (buyer beware) works!

So how did they make this great discovery?  They began by asking

Do differences in bank supervision, regulation and information availability affect the relationship between capital and systemic risk in countries? Can capital substitute for weak institutional structures? What elements of the institutional environment matter most for the capital-systemic risk relationship?

To answer these questions,

In principle, bank capital should have a greater impact in countries where market discipline is weak … thus the impact of bank capital should be less pronounced in markets with greater information availability and symmetry. Efficient private monitoring also depends on information availability and sharing, hence we would expect bank capital to have a greater impact when private monitoring is less efficient.

And what did they find?

We find that the effect of capital on systemic risk varies significantly across countries.  In particular, the link between capital and systemic risk is weaker in countries with institutions that foster effective public and private monitoring of banks.  This finding suggests that capital can substitute for oversight in reducing systemic fragility. We also find that countries where transparency is limited and market participants face greater information asymmetry benefit more from higher bank capital.

Shorter:  the combination of transparency and buyer beware works.

One final observation about this study:  how do you measure transparency when publicly traded banks around the world do not disclose the information needed so an investor could know what they own?

The 2008 collapse of Lehman Brothers and the 2009 collapse of Dexia highlighted the fact bank capital does not substitute for transparency in reducing systemic financial fragility. Both of these financial institutions reported the highest or close to the highest capital ratios in their peer groups shortly before collapsing.