When bank employees are afraid of punishment from regulators, they are likely to conceal information about their faulty decisions. This in turn distorts the truth in financial reporting and undermines financial stability. Alternative models could improve regulator-firm relationships and encourage cooperation of bank employees.

The information provided by large banks to their regulators can help promote systemic stability. Yet, regulatory and supervisory practices in some cases might induce obfuscation of information by bank employees, thus harming the quality of financial reporting to the detriment of financial stability and bank investors. Research takes the role of regulation and supervision on disclosure and financial reporting as given, and rarely considers that the information disclosed and priced in the market may reflect supervisory practices.

The aim of this piece is to identify the tension and challenges between banks and their regulators about disclosure of faulty business decisions. The tension stems from the fact that regulatory expectation does not take into account the incentive of bank employees (and management) to disclose. The following also attempts offer a path to establishing a potentially more effective dynamic for disclosure by banking firms to their regulators.

A key attribute of good governance for listed companies is disclosure to outside stakeholders. Listed firms often disclose information to their investors and other stakeholders beyond regulatory filings and compliance with the SEC. Disclosure to investors is public and impacts firms’ valuation and cost of capital.  Firms in the financial sector face another entity to which they must report developing events – their regulators. Commitments to inform regulators of new developments at a bank come from a set of laws, regulations, and (formal or informal) guidance designed to reflect the public interest in safe and sound financial institutions.

Regulators do not interfere with the bank decision to make certain information public, but they often conduct a detailed investigation after a disclosure.  Banks also routinely disclose information to their regulators.  Some disclosure is mandated by law and will be made public. Other disclosures are related to ongoing business activities. Unlike disclosures to outside stakeholders, disclosures to bank regulators that are specific to business activities remain private. Some disclosure could be about business practices that might be faulty.

A bank’s decision to disclose to regulators is motivated by two reasons: (1) an incentive to cooperate and avoid criticism and (2) a wish to limit punishment. Incentive to disclose to regulators has been studied in law and economics in the context of enforcement and self-reporting. An important insight is that firms consider disclosing if the fine associated with self-reporting is smaller than an uncertain punishment should regulators uncover the problem on their own.

“This suggests that there could be potentially large number of unreported faulty cases at any large bank.”

An example of private disclosure to a regulator might shed light on the issue of strategic disclosure. According to observers close to the case, around 2015, a bank contacted its supervisor, the Federal Reserve Bank of New York (FRBNY), about a decision by the bank, let’s assume a trade. The bank wanted to inform the FRBNY about a specific trade, something that its regulator might not have learned about. After a trade was executed, the bank stated that its staff wondered if the trade was within the allowed guidelines. The FRBNY assessed the trade execution and ruled that it was done properly. The protocol requires that cases reviewed at the bank level be communicated to the Federal Reserve System Board of Governors (the Board). The Board reassessed the case and ruled that the trade was, in fact, illegal. (one can speculate that the Board was also critical of the FRBNY’s handling of the case.) Whether or not the bank subsequently was fined is not critical to the discussion, although imposition of a fine lends further support the argument that fear of punishment could reduce the incentive for voluntary disclosure to regulators.

The example offers at least two takeaways. First, the incentive to self-disclose might reduce the cost of a business decision by the firm if regulators later determine that the decision was outside the permitted guidelines. Thus, by disclosing to regulators, management is likely to avoid close monitoring, and perhaps loss of discretion and fines.  Second, strategic disclosures to regulators could be costly to the firm, thus firms could opt out of disclosure to their regulators.  Therefore, failure to disclose could in effect interfere with financial stability as regulators might not learn what a bank is doing and thus mitigate a potentially bigger problem.

The assumption in the discussion of self-reporting is that the firm knows about most faulty practices. This is not likely as large firms have about 250,000 employees and can’t monitor every decision in such a large group. Fear of punishment might keep bank employees from sharing critical information with senior management, a challenge to bottom-up information flow. If a poor business decision is reported to management and shared with regulators, the likelihood is that the firm will be punished and some employees might be terminated (although not the management). Termination is intended to convey to regulators that the bank is fully cooperating. In fact, the data provides evidence that regulators participated in termination of lower rank employees in some banks. Anticipating the consequences ex ante, problems are rarely reported to management by employees unless they are severe. Employees might make subjective choices on what is and is not critical for reporting. If an issue is reported to management and subsequently is not made known to regulators, then management could face difficulty, which is potentially a bigger problem for the bank. The consequence is the potential adverse impact of failure to report on quality of financial reporting, for example, losses may not be recognized for a while. If so, this is costly to investors as well as a risk to financial stability.

Given the adverse effect of a bank’s unreported poor business decision on financial stability and the economy, the critical question is that how do poor decisions, malfeasance, lying get discovered in the absence of voluntary disclosure. Consider a trader who ran the collateralize debt obligation book at a large bank. His positions weren’t that risky according to observers, but markets moved against his Residential Mortgage-Backed Securities (RMBS) longs faster than his hedges made money, and he decided not to take any losses by keeping some prices stale.  There were many procedures designed to control for this, but several failed and one was quite late (the one that got him). The cost of his late disclosure was quite high. It is difficult to know his thought process, but one can speculate that – like many previously successful traders, he figured he could ride things out, and/or make enough money elsewhere to absorb the problem (at least in the early stages).

The example underscores the complexity and behavioral consequences of disclosure to regulators due to fear of punishment. This suggests that there could be potentially large number of unreported faulty cases at any large bank. If so, then the question is how regulators should address the disclosure problem. Regulators are unlikely to have any instrument to encourage good conduct, also any cooperation with banks could be perceived as capture and induce negative publicity about the role of supervision and thus soundness of the financial system. Supervision is about overseeing and enforcing compliance, and punishment if needed. In an economic context, regulation is an exogenous factor influencing bank conduct and bank norm. If failure to communicate faulty business decisions to management and then to regulators is a norm in the banking firms, then could regulation and supervision be a contributing factor?

Should regulators motivate disclosure and, if so, how? An important public policy aim then would be to craft a framework for disclosure by banks to their regulators, beyond compliance. In organizations and in public policy, escalating information about faulty practices could help with better decision making. How regulators can encourage the flow of information about poor business decisions to supervisors is not easy. Perhaps firms should be rewarded when they provide information very early as sign of cooperation (although it is likely that an employee who shares the news of a faulty decision with his employer will face damage to his earnings capacity), administered some punishment for very late disclosure, and issued a much larger punishment when regulators uncover the problem on their own. Also, regulators could learn from other informal settings in the financial markets. For example, lending market could be a model for bank-regulator information sharing. The market offers an implicit reward for a firm that approaches its bank, for example, for a covenant waiver in response to some financial problems, before defaulting (which would impose a large cost on the lender). Informally, negotiations occur outside default, which suggests that borrowing firms see a benefit in contacting their bank before they have to. If this approach works for lenders, then why can’t a similar dynamic be adopted by banks in their relationships with regulators? Alternative, banks can solve some informational problems internally by altering adopting compensation deferral as a way to incentivize early disclosure to regulators.

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