Banks' versus regulators' disclosure choices in the presence of adverse selection and runs

Abstract

The transparency of banks about the prospects of their risky assets is an issue of great importance. In this paper, we present a theory of disclosure in which banks face both adverse selection and bank run risk. While information disclosure about banks' assets can reduce adverse selection in credit markets and foster investments by banks, it can also trigger bank runs. If deposits are insured and without bank run risk, banks and the regulator choose similar disclosure policies to mitigate adverse selection and spur investments. Otherwise, if deposits are uninsured, bank runs are socially efficient or inefficient depending on banks' investment decisions. Banks with large deposit rates tend to disclose more information than what is socially optimal to obtain cheaper financing, which is suboptimal because it exposes banks to inefficient runs. In contrast, banks with smaller deposit rates tend to disclose less information than what is socially optimal to maximize investments. The regulator then wants more disclosure to increase the probability of efficient runs and to prevent those banks from making value-destroying investments. Our model carries important policy implications and also delivers several empirical predictions consistent with recent empirical findings.

Keywords: Adverse selection, Banks, Disclosure, Investment efficiency, Runs, Transparency

JEL Classification: G21, G28, M41, M48