Supervisory Disclosure during a Financial Crisis: Evidence from the EU-wide Stress-Testing Exercises

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1 Supervisory Disclosure during a Financial Crisis: Evidence from the EU-wide Stress-Testing Exercises Jannis Bischof / Holger Daske University of Mannheim Mannheim, June 16, / 27

2 Dieses Wort, ursprünglich aus der Humanmedizin stammend, begegnete im Laufe des Jahres auffällig oft. Es erwies sich dabei aus sprachlicher Sicht als äußerst produktiv und war in den verschiedensten Bereichen anzutreffen: Nicht nur Banken wurden auf ihre Belastbarkeit getestet, auch etwa das Bahnhofsprojekt Stuttgart 21, die grün-rote Landesregierung in Baden-Württemberg und deutsche Atomkraftwerke wurden Stresstests unterzogen. Diese Praxis und somit das Wort erlangten dadurch politische, wirtschaftliche und gesamtgesellschaftliche Relevanz. So ist Stresstest mittlerweile als fester Bestandteil der Alltagssprache anzusehen. - Gesellschaft für deutsche Sprache 2 / 27

3 Introduction Motivation Evaluation of Stress-Testing Exercises Regulator s perception U.S. experience in 2009 (e.g., Bernanke 2010; Turallo 2010; Dudley 2011) Perceptions in the press Stock price / CDS reactions Individual cases, e.g. Bank of Ireland, Allied Irish Banks, Daxia Conceptual discussions [Microprudential vs. Makroprudential] Chicago Booth Report (Greenlaw, Kashyap, Schoenholtz, Shin 2012) BIS Report (Borio, Drehmann, Tsatsaronis 2012) 3 / 27

4 Introduction Motivation Missing evidence Question of disclosure hotly debated: Disclosure. This was hotly debated - Dudley, President NY Fed (2011) One EU official said that the decision to publish had been reached only after a big battle at the summit. - Financial Times, June 18, 2010 One reason for the success of the stress-test was the public disclosure of the results. - Bernanke, Chairman Federal Reserve System (2010) We welcome the publication of stress tests which are an important part of ensuring market confidence and promoting market discipline. - U.K FSA (2011) Allerdings frage ich mich, ob die EBA bzw. die nationalen Aufseher die Ergebnisse jedes Mal veröffentlichen sollten. Und ganz offen bin ich von einer Veröffentlichung außerhalb der Krisenzeiten nicht überzeugt. - Sabine Lautenschläger, Deutsche Bundesbank (2011) 4 / 27

5 Introduction Research Question We study consequences of supervisory disclosure of proprietary information about banks risk positions: Financial market uncertainty versus Incentive to reduce risk-taking (market discipline) 5 / 27

6 Setting Stress-Test Disclosures Stress-tests are a standard tool of prudential supervision. However, disclosure of stress-test results is rare. SCAP in the U.S. is a combination of disclosure and re-capitalization EU stress test is a pure disclosure event 6 / 27

7 Setting Stress-Test Disclosures 1 Sovereign credit risk exposure 2 Regulatory capital simulation under adverse economic conditions 7 / 27

8 Setting Stress-Test Disclosures Disclosure frequency and commitment CEBS and EBA explicitly do not commit to repeated disclosures One-time mandatory disclosure The EBA s charter requires... stress tests... on a regular basis, but doesn t stipulate that they have to be every year. It all depends on the situation when they are appropriate, the spokeswoman said. 8 / 27

9 Prior Literature Direct Effects of Stress-Test Disclosure Market updates expectations Information content (event-study) Peristian, Morgan, Savino (2010), NY Fed Staff Report Ellahie (2012, WP) Stock price reactions around announcement events Pro: Identification Contra: Evidence from press-reports 9 / 27

10 Prior Literature Direct Effects of Stress-Test Disclosure Equity Market Reactions around the European Stress-Test Disclosures 10 / 27

11 Prior Literature Direct Effects of Stress-Test Disclosure CDS Market Reactions around the European Stress-Test Disclosures 11 / 27

12 Hypotheses Indirect Effects of Stress-Test Disclosure 12 / 27

13 Research Design Sample and Data Sample of 280 financial institutions (82 stress-test participants, two control groups) Disclosure data Screening of all IFRS annual, interim and supervisory Pillar 3 reports for sovereign credit risk disclosures (2,047 reports) Identification strategy Challenge 1: Stress-test effect vs. increasing market demand Exploit increasing level of required information (phase-in) 13 / 27

14 Research Design Sample and Data Disclosure items over time July 2010 July 2011 Dec 2011 Sovereign Exposure Total EAD x x x Trading Book x x x Banking Book x x x FV Option x x AFS x x Derivatives x x Maturity Analysis x x CDS x Non-sovereign Exposure Total EAD x 14 / 27

15 Research Design Sample and Data Challenge 2: Control for magnitude of exposure? Risk-taking data Magnitude of exposure to PIIGS countries (stress-test template) Market price sensitivity to changes in PIIGS CDS spreads R it = β 0 + β 1 R MI jt + β 2 R IBOR jt + β 3 R PIIGSCDS t + ɛ where: R it is the buy-and-hold stock return for bank i in week t R MI jt is the return for country j s local stock index in week t R IBOR jt is the percentage change of country j s local 3-month interbank offered rate in week t R PIIGSCDS t is the percentage change of a self-constructed index of CDS net premia on 5-year sovereign bonds issued by the five PIIGS countries in week t 15 / 27

16 Results Sovereign Risk Disclosures around Stress-Testing Exercises Univariate Analysis: Reporting period immediately before vs. immediately after mandatory stress-test disclosures 16 / 27

17 Results Sovereign Risk Disclosures around Stress-Testing Exercises 17 / 27

18 Research Design Sovereign Risk Disclosures around Stress-Testing Exercises Multivariate Analysis: Change in Disclosure it = β 0 +β 1 Post-Stress Test t +β 2 Stress Test Participation i + β 3 Post-Stress Test t Stress Test Participation i + β j Control j + ɛ Identification strategy: Link change in voluntary disclosure behavior to (1) timing and (2) content of mandatory stress-test disclosures Diff-in-diff design (interaction term) Conditional fixed-effects logit to control for systematic and time-invariant differences between participants and control groups Time-variant controls for changes in the level of PIIGS CDS spreads and firm-level analyst following (proxies for market demand) 18 / 27

19 Results Sovereign Risk Disclosures around Stress-Testing Exercises Multivariate Analysis: 19 / 27

20 Results Sovereign Risk Disclosures around Stress-Testing Exercises Multivariate Analysis: 20 / 27

21 Results Sovereign Risk Disclosures around Stress-Testing Exercises Change in voluntary sovereign risk disclosures observed for 50.91% of stress-test participants, but only for 13.14% of other financial firms Result robust to controls for differences in firm-level exposure, reporting incentives, etc. (multivariate analysis) Commitment to sovereign risk disclosures is associated with a mitigating effect on rising bid-ask spreads (general upward trend) Result is consistent with one-time mandatory disclosure providing incentives to reduce bank opaqueness in the long run 21 / 27

22 Research Design Risk-Taking Behavior around Stress-Testing Exercise First approach Change in reported sovereign exposures between December 2010 and September 2011 (EBA templates) Use of credit risk disclosures to identify stress-test effect Low measurement error in exposures, however: no benchmark group Second approach Change in market price sensitivities to changes in PIIGS CDS premia (10 months before and 10 months after submission of 2011 stress-test results) Data availability for benchmark groups, however: large measurement error 22 / 27

23 Results Risk-Taking Behavior around Stress-Testing Exercise Univariate Analysis of Reported Sovereign Exposures: 23 / 27

24 Results Risk-Taking Behavior around Stress-Testing Exercise Multivariate Analysis of Reported Sovereign Exposures: Reported PIIGS Sovereign Risk Exposure i = β 0 + β 1 Stress Test Result i + β j Control j + ɛ 24 / 27

25 Results Risk-Taking Behavior around Stress-Testing Exercise Multivariate Analysis of Market Price Sensitivities: 25 / 27

26 Results Risk-Taking Behavior around Stress-Testing Exercise Approach 1: Exposure to PIIGS countries as reported on the EBA templates (December 31, 2010 to September 30, 2011) Negative stress-test result (simulation gap > 30%, conditional fail, restructuring) associated with a larger decrease in reported risk positions Approach 2: Market price sensitivity to changes in PIIGS CDS spreads (10 months before and 10 months after April 30, 2011) Decrease in price sensitivity is larger for stress-test participants than for control group Cross-sectional heterogeneity based on stress-test result 26 / 27

27 Results Risk-Taking Behavior around Stress-Testing Exercise Market uncertainty (liquidity sensitivity and liquidity volatility) increases for stress-test participants relative to control groups Increase is mitigated for sub-groups of participants that reduced their sovereign credit risk exposure By providing incentives to reduce the level of risk exposure, supervisory disclosure may have an indirect effect on financial market uncertainty 27 / 27

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