I have attached the Assignment breif and Example of the assignment as well , for how it should be made which will make it easy for you. SUBJECT NAME- BUSINESS RESEARCH METHODS.
THE EFFECTS OF TRANSPARENCY ON THE STABILITY OF INTERNATIONAL BANKS 2 ABSTRACT Banks have an important role to play in an economy, resource allocation being the primary function of banks. The financial crisis of 2007 to 2008 has raised questions on the stability of the financial sector since it affected commercial lending drastically. Banks are deemed to be less transparent relative to other non-financial firms operating within an economy, even though they face the same kind of competition and corporate governance issues like non-financial firms. Thus, making it tough for investors to determine the financial performance and position of banks. This is because loanable funds are the largest asset group for banks, which makes the banking sector important to be researched on. It is therefore essential to understand the effect of transparency on bank stability. Mixed results are found on whether transparency is beneficial or harmful to bank stability. Research shows that accounting standard setters are in favour of transparency while bank regulators are against it. The results could have policy implications, in that, an optimal level of transparency could be identified. 3 1. Introduction The literature review discusses the benefits and costs of transparency on the stability of banks around the world. Google scholar and SSRN e-journal has been widely used to search for articles that relate to banks. Journals selected include journal of economics, journal of financial intermediation and journal of financial economics. The Australian Business Deans Council (ABDC) has been used to check the rankings of these journals. Search terms included bank transparency, bank stability, banks, similarity with non-financial firms. The focus was on commercial banks and non-financial firms have been excluded from the study. The discussion on the transparency does not identify the elements of financial reporting that affect stability. 1.1 Banks: Background discussion Banks plays a number of important roles in a country including resource allocation, monitoring investments, diversification, managing risks and providing services to businesses and households for day-to-day transactions (Bushman 2014). However, due to the financial crisis that took place in the period between 2007 to 2008 resulted in the collapse of a few commercial and investment banks such as Lehman Brothers, Merril Lynch and Wachovia (Barth and Landsman 2010). An outcome of the financial crisis was that the banks faced challenges on which commercial lending is dependent. Banks, like non-financial firms must face competition and corporate governance issues. However, in the case of financial statement presentation, the composition of the balance sheet is quite different from those of non-financial sectors. Tayi and Leonard (1988) in their study describe loanable funds to be the raw material of a bank that are based on private information. Thus, it has been asserted that outside investors face difficulties in valuing bank assets (Flannery, Kwan and Nimalendran 2004). Several researches conducted have justified the banking industry to be informationally opaque relative to non-financial industries, which could have either a beneficial or bad effect on bank stability (Morgan 2000; Blau, Brough and Griffith 2016; Fosu et al. 2017). 1.2 Bank transparency and Bank stability Bank transparency has been defined by Bushman (2016, p-129) as “the availability to outside stakeholders of relevant, reliable information about the periodic performance, financial position, business model, governance, and risk of banks.” On the other hand, bank stability is based on the activities of all banks since they are linked to or independent on each other. 4 Brunnermeier et al. (2009) defines bank stability as “the absence of banking crisis achieved through the stability of all banks in the banking system or sector.” Transparency occurs when information disclosed is effective in reaching the market and it depends on users ability to adequately interpret the information provided (Freixas and Laux 2011). However, there have been contradicting beliefs between bank regulators and accounting regulators on the extent to which transparency enhances bank stability. Bank regulators argue that bank transparency may pose threats to banking stability whereas accounting regulators advocate for transparency since it limits income smoothing (Gaston and Song 2014). There is a conflict between the goals of bank regulators who underline the importance of sound and safe banks and accounting standard setters who prioritize transparency of financial statements. 1.3 Positive effects of transparency on Bank Stability Transparency plays a major corporate governance role. It has been asserted that banks are relatively less transparent than other non-banking firms (Morgan 2000). Thus, giving rise to agency problems which is as a result of information asymmetry. Asymmetry occurs because managers would have better firm specific information than outsiders and managers are unlikely to report information that is detrimental to them, including poor performance or bad news (Verrecchia 2001). Therefore, publicly available information is used to monitor the actions and performance of top executives through incentive compensation contracts that is used to align interests of investors and managers (Bushman and Smith 2003). Thus, banks should communicate their financial position and performance in a timely manner to enable users make rational decisions (Admati and Pfleiderer 2015). Enhancing transparency could also reduce the number of bank panics that occur in an economy. Huang and Gorton (2006) provide evidence of bank panics between small and large banks. In their study, it is shown that banks in the United States that are large and well diversified are less prone to bank failures and panics. Bank panics results from a situation whereby depositors monitoring the banks, lack information about the bank assets’ value and during recessions they withdraw from banks. This occurs because depositors are unaware of banks engaging in moral hazard. Thus, transparency is a means to mitigate panics and roll over risks by reducing the uncertainty about the solvency of individual banks (Ratnovski 2013). Furthermore, market discipline is viewed as a process through which market participants monitor the behaviour of banks and transparency plays an essential role in fostering it (Bushman and Williams 2012). In a study conducted by Blum (2002), market discipline has 5 been measured using subordinated debt, a valuable tool to monitor and reduce risk taking behaviour by banks. Subordinate debt holders are the first creditors to bear losses in case banks take risky investment decisions. As a result, informed investors will demand a higher risk premium to compensate for the higher risk entailed in their investments. Granja (2011, p-5) highlights that “disclosure regulation could have a positive effect on financial development and stability by facilitating the regulatory efforts to wind down a distressed banking system.” It has been asserted that higher bank transparency is beneficial in the auction process of distressed banks. There are lower costs associated with disclosing more and disclosure is a means to promote mergers and acquisitions of distressed banks by the healthy and stable banks. Similar views regarding benefits of disclosure information has been shown by Peek, Rosengren, and Jordan (2000). They state that supervisory disclosure provides valuable information not only for the bank making the announcement but also gives an idea about the health of banks in the same region with similar portfolios and risks. They conclude that enhanced transparency can improve resource allocation in the banking industry. 1.4 Negative effects of bank transparency on bank stability Considering the dark side, transparency could cause market illiquidity. Holmström (2008) gives an example of a company selling wholesale diamonds to explain how transparency may not be beneficial to a firm. Diamonds are placed in packets that customers are prohibited to investigate, and they are sold based on take it or leave it. Holmström (2008) argues that if buyers could inspect the packets to get a better estimate of their value, it would either slow down trade or halt trade completely. Thus, eliminating adverse selection problems in the market. Even though transparency is important in corporate governance issues (Bushman and Smith 2003), it may not enhance financial stability. In a study conducted by Fahlenbrach and Stulz (2010) on ninety eight commercial and investments in USA found no evidence of higher stock returns during the crisis despite better alignment of Chief Executive Officers (CEOs) and shareholders of banks. Instead, some evidence of worse stock returns and decreased return on equity was found, even though the interests of bank CEOs and shareholders were better aligned. Their results show good corporate governance in banks, however, conflicting with the financial stability of banks. 6 A study done by Chen and Hasan (2006) investigates the relationship between transparency of banks and the fragility of the banking system predict that “contagious bank runs are more likely to occur when the correlation between banks’ return is higher.” Small and weaker banks are likely to suffer bank runs and this negatively affects the stability of the banking system since depositors are likely to withdraw from all banks when they have information relating even to just one bank. In relation to bank runs, Morrison and White (2013) show that even when the return on assets in which two banks invest are uncorrelated, the failure of one bank may cause bank runs affecting the second bank. Contagion bank runs occur because depositors lose confidence in the bank regulators competence. Even though, Chen and Hasan (2006) and Morrison and White (2013) both show that bank runs cause instability in the banking sector due to contagious bank runs, they use different factors to analyse their results. The latter show that interbank lending and correlation in returns on banks are described as the sources of contagion, however, there is another factor that should be considered, that is, common regulator of these banks. Having high correlation in returns is not enough to explain bank runs, instead having a common regulator affects them. It has been asserted that bank stability is disrupted by bank runs. However, the factors influencing bank runs is not clear. On the one hand, it is argued that small banks are more vulnerable to bank runs, while some argue that regulators competence causes bank runs to occur. Furthermore, Similar to Huang and Gorton (2006) findings, weaker banks are more prone to bank runs. However, there seem to be contradicting views on whether improvements in transparency could increase the chance of inefficient contagious runs on other banks (Chen and Hasan 2006) or reduce it. 1.5 Conclusion Banks are important due to its significant role of resource allocation in an economy (Allen and Santomero 1997). Banks financial statements are different from non-financial firms because loans form an important part of their assets. Thus, making the banking sector less transparent due to the asymmetric information between banks and depositors (Beatty and Liao 2014). It is therefore important to understand the effects of transparency on banking stability. Several benefits of bank transparency have been highlighted above, including improved corporate governance, enhancing market discipline and reducing costs associated with bank auctions. These benefits have an impact on bank stability because information asymmetry 7 reduces between banks and investors. However, a couple of disadvantages have also been shown when transparency is enhanced, these include, contagious bank runs, lack of confidence in regulator competence, slower trade and illiquid markets. Accounting Standard setters and bank regulators have differing opinions on whether transparency hinders or enhances stability in bank (Gaston and Song 2014). According to Bushman and Williams (2012) financial reporting aims to provide information to outsiders about the firm to enable them make rational decisions. On the other hand, bank regulators aim to reduce the risk levels to which depositors are exposed to and to mitigate bank risks (Rochet 2005). It is thus, unclear whether transparency negatively or positively affects bank stability. Bank runs have been found to be a drawback of increased transparency. However, the factors influencing bank runs is unclear. Some studies show that high correlation of returns is a cause of bank runs, while others argue that even when uncorrelated bank returns are reported bank runs are still present. Furthermore, the role and reputation of a common regulator is believed to cause bank runs. When a bank fails, other banks under the same regulator are deemed to suffer causing bank runs across all banks with the common regulator. Information disclosure has been found to enhance resource allocation in the banking sector since supervisory announcements reflects the status of other banks with similar portfolios. Thus, transparency represents positive spill over effects (Peek, Rosengren and Jordan 2000) rather than representing contagion (Chen and Hasan 2006). Thus, the conflicting views on transparency creates demand for further research to be undertaken. This would provide insights on whether transparency is healthy or detrimental for the banking system and in which scenarios does transparency affect Australian banks. The mixed results could have policy implications, since an optimal level of transparency needs to be identified. Another potential area for research includes determining the effects of financial reporting quality in reducing information asymmetry in banks, this is because