The global financial crisis of the new millennium has brought to light the inherent fragility of the financial system and made more urgent the need for policy reforms to enhance its robustness against future shocks.
The opaque world of securitization and credit derivatives in subprime mortgages, which served as the breeding ground for the crisis, has brought attention to the age-old question of whether enhancing transparency can promote the stability of the financial system.
The objective of this article is to provide a short review of the issues surrounding the relationship between banking transparency and the stability of the banking system.
The theoretical as well as the empirical case for transparency as an enhancer of banking system robustness is not without controversy.
However, despite conflicting views, there is a consensus that transparency, while not a panacea against systemic turbulence in financial systems, plays a significant role in enhancing banking system stability.
Crises have been a common feature of banking systems for a long time—the United States alone experienced 11 banking panics between 1800 and the beginning of World War I (Beim and Calomiris, 2001). The crises of recent times have, however, been rather severe. The full range of costs linked to the 2007–09 financial crisis may not be easily estimable. While initial gross government commitments to deal with the crisis have reached between 20% and 30% of GDP in developed markets (Schildbach, 2010), the effective fiscal outlays so far have amounted to 3.5% of GDP in G20 countries, with gross output losses projected to be much higher. In earlier crises the costs of bailing out troubled banks in a banking crisis ranged between 20% and 50% of a country’s GDP, with a resolution time that could extend up to nine years (Honohan and Klingebiel, 2000). Hoggarth and Saporta (2001) report the average fiscal costs of resolving a banking crisis to be about 16% of GDP, with cumulative real output losses stemming from a banking crisis put at more than 17% of GDP. As an example, the cost to Indonesia of resolving the crisis of 1997 is estimated to have been 50% of its GDP.
The global crisis, coupled with the massive recurrent financial turbulence of the late 1990s, brought to the fore the public debate on the potential role of increased disclosure and transparency in strengthening market discipline in relation to the financial sector. In its report to the G7 finance ministers, the Financial Stability Forum (FSF), for example, calls for financial institutions to strengthen their risk disclosure and for supervisors to improve risk disclosure requirements under Pillar 3 of Basel II (FSF, 2008). Enhanced transparency via greater disclosure of accurate and timely information about constituent financial institutions is believed to facilitate an objective assessment of the financial health of banks by market participants, inducing market discipline that could reduce the likelihood of systemic turbulence in the banking sector.
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