The Impact of Transparency on Banks’ Loan Loss Provisioning: A Closer Look at Privately Held Banks

Transparency plays a pivotal role in maintaining stability and trust in the banking sector. However, in many countries, a significant fraction of banks is privately held, with few incentives for transparent disclosures and notoriously low pressure from stakeholders absent any capital market. In fact, the traditional business model of these banks relies on a certain level of proprietary knowledge and confidentiality. Privately held banks are thus worth a closer look when it comes to transparency regulation.

Our study “Does Greater Transparency Discipline the Loan Loss Provisioning of Privately Held Banks?” (forthcoming at European Accounting Review), uses the German implementation of an EU regulations that promotes bank transparency and investigates whether greater transparency disciplines managerial behavior. Specifically, we assess the loan loss provisioning of privately held banks which is critical for bank lending and risk-taking as many prior studies have shown (e.g., Beatty and Liao 2011; Bushman and Williams 2012). Our setting has the advantage that it holds the recognition and valuation rules constant. That is, we can solely focus on the effect of more transparent disclosures. We take advantage of proprietary supervisory data provided by the Deutsche Bundesbank, the central bank in charge of banking supervision in Germany. The data enables us to track loan loss reporting even before the first mandatory disclosure, i.e., when the loan losses were not publicly reported.

The research uncovers four essential findings:

1. Transparency Disciplines Provisioning: Public disclosure significantly reduces opportunistic provisioning practices by privately held banks, especially its use for income smoothing, even without capital market pressure.
2. Improved Information Content: The change in provisioning behavior is economically meaningful because it enhances the information content of loan loss provisions for future losses.
3. The Context Matters: The response to public disclosure varies across banks, depending on the incentives of their stakeholders to exploit the new information. Banks with less secured funding and those in regions with more competitive local newspaper markets are more affected by the transparency change.
4. Transparency Has Consequences: The reduction in reporting opportunism leads to better mapping of loan loss provisions into future charge-offs and improvements in the loan portfolio quality, consistent with the notion of transparency as a means of assuring market discipline.

Key Take-away

In conclusion, the paper underscores the vital role of transparency in shaping bank behavior, also for privately held banks. Ultimately, transparency remains a key tool in maintaining trust and accountability in the world of banking and finance. At the same time, our evidence suggests that transparency works well even in the absence of capital market pressure, informing a much broader literature, e.g., on the consequences of the recently mandated ESG-related disclosures.

Our study that is forthcoming at European Accounting Review provides more insights that can be found here.