GLOBAL financial DEVELOPMENT REPORT 2013
exposed, potentially causing significant disruptions in credit markets and contributing to systemic risk. Bartlett (2012) argues that redesigning bank disclosures to facilitate credit modeling by market participants has the potential to meaningfully increase market discipline while minimizing the disclosure of sensitive bank data. He illustrates how even basic credit risk modeling, when combined with appropriate bank disclosures, could have significantly enhanced investors’ ability to detect the portfolio risk leading to two recent severe banking crises. Moreover, because such an approach leverages the same aggregate metrics banks themselves use to monitor their risk exposure, the proposed disclosure regime would impose a limited disclosure burden on banks while avoiding the need to reveal sensitive position-level data. It would be naive, of course, to think that all creditors, investors, and analysts have the resources and capacity to understand, assess, and identify these increasingly more complex structures, institutions, and instruments. Indeed, the collective tendency of financial firms, nonfinancial corporations, and households to overexpose themselves to risk in the upswing of a credit cycle, and to become overly risk-averse in a downswing, has been well documented. These tendencies raise some questions about the capacity of financial markets and investors to instill discipline on the behavior of financial entities, and they underscore the importance of having both strong supervision and market discipline. One of the important advantages of complementing strong supervision with market discipline is that, with sufficient disclosures and proper incentives, investors and analysts would be more likely to develop their own assessments of capital adequacy and liquidity, and there could be scope for competition and evolution in the design of the most appropriate measures. This approach would limit the likelihood of “groupthink” and focusing too much on a single and possibly flawed proxy or rating system. Ultimately, the approach would help in limiting the buildup of risk that occurred prior to the financial crisis.
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Further improvements in transparency and disclosures are seriously needed, both on the systemwide level and on the level of individual financial institutions. As regards the disclosures on systemic risks, many countries have been publishing so-called financial stability reports. Recent research on the subject suggests that simply publishing a financial stability report seems to have no impact on financial stability (Čihák, Muñoz, Teh Sharifuddin, and Tintchev 2012). The effectiveness of such reports in signaling and addressing systemic risk has, however, been affected by a number of factors. In the absence of a unifying analytical framework for assessing systemic risk, most financial stability reports were rather descriptive and refrained from explicit statements about the level of systemic risk present in the financial system. Data gaps, particularly in the nonbank sector, led many reports to focus on the banking sector, impeding a true systemwide perspective. Also, the articulation of financial stability analysis into remedial policies, aimed at curbing the buildup of systemic risk, was problematic. There is thus substantial scope for improving such reports (as well as the associated information on systemic-level risks) in terms of clarity, consistency over time, and coverage. The ongoing work on good practices in macroprudential surveillance (such as Nier and others 2011) could usefully address transparency and disclosures of systemic risk. At the level of individual financial institutions, further reforms are needed to ensure a higher quality of disclosures. Much reliance has been placed on the external auditors, a sector that came to be dominated by the “Big Four” (KPMG, PwC, Ernst & Young, and Deloitte). In the run-up to the financial crisis, many financial institutions were given a clean bill of health by the external auditors, only to be bailed out a few months later as the financial crisis unfolded. In the wake of the crisis, the European Union has proposed a draft law to tighten supervision of the external auditors. At the global level, the FSB has requested action from several global bodies to ensure greater international consistency in audit practices, and to provide more specific