Many bank depositors may not know if their bank is financially healthy or weak, or whether it has made too many risky loans that threaten its future. But contrary to popular perceptions, depositors do care about their bank’s financial health, and about whether federal deposit insurance will protect their savings. How transparent banks are about their finances will help depositors decide on where they want to park their savings, according to a recent paper by experts at Wharton and elsewhere.

Depositors’ sensitivity to bank transparency is crucial because they account for 70% of bank funding, and also because their choices impact deposit rates, investment patterns, and profitability of their banks, according to the paper, titled “Bank Transparency and Deposit Flows.” Wharton finance professor Itay Goldstein co-authored the paper with accounting professors Qi Chen and Rahul Vashishtha at Duke University and Zeqiong Huang at Yale University.

Goldstein said their paper is the first empirical study that links the transparency of banks to depositor behavior. In other words, it attempts to measure how depositors respond differently when banks have different levels of transparency. It is also the only study that explores the consequences of transparency through the lens of its effect on the performance sensitivity of uninsured deposits. Furthermore, it brings out the costs of transparency for banks in terms of higher external funding costs and lower profitability.

Analyzing Bank Finances

Banks disclose details about their finances in quarterly Call Reports. The paper noted that a typical depositor may not be willing to invest the requisite time and resources to understand those disclosures, “especially if they believe that government support will limit their losses in the event of bank failure.” The Federal Deposit Insurance Corp (FDIC) provides deposit insurance of up to $250,000 per depositor, per bank and for each account category, but it does not cover credit unions and stocks, bonds, and mutual funds, among other securities.

The paper’s authors analyzed bank Call Reports covering 25 years from January 1994 to December 2019, and created a metric called R2 to capture the degree of bank transparency in disclosures; they used that metric to assess the sensitivity to transparency of both insured and uninsured deposits. The final sample of the study covered call reports from more than 9,000 banks, of which 27% are publicly listed, and the rest are private banks.

“Transparency is a mixed bag: It has some positives and some negatives.”— Itay Goldstein

The paper defined R2 as “the informativeness (transparency) of bank earnings” and loan write-offs, loan loss provisions, and other key disclosure items that predict loan write-offs. In other words, R2 reveals the informativeness of disclosures about the current quality of bank loans, and the size of anticipated write-offs for bad loans. Banks with higher R2s are more transparent as their disclosures contain more information about their asset quality, the paper explained. The paper also covered the effects of the 2002 Sarbanes-Oxley Act that raised the bar on reporting and disclosure requirements by corporations.

Deposit growth at a bank is a function of four factors that the paper listed: (i) default risk, (ii) deposit rate, (iii) service quality, and (iv) changes in aggregate demand for deposits. Assuming other factors such as deposit rates are equal in a competitive environment, banks could attract or lose deposits depending on depositors’ perceptions of their risk of default. The study also found that stock returns are more sensitive to earnings news in banks with high R2.

The economic magnitude of bank transparency is significant: “a one-standard-deviation increase in R2 is associated with a 26% increase in the flow-performance sensitivity,” the paper stated. That means the flow of deposits will be more sensitive to bank performance when the bank’s transparency is higher. Goldstein explained that: Suppose that for every one percentage point decline in performance, a bank loses one percentage point of deposits. If a bank is more transparent, then for a one percentage point decline in performance, it will lose 1.26 percentage points in deposits.

Depositors at banks with high default risk would of course care much more about information on that. The study did find “a highly statistically significant positive relation” between the R2 measure and the sensitivity of uninsured deposit flows to bank performance, particularly for poorly performing banks.

The Two Sides of Transparency

The paper noted that while transparent banks can offset the sensitivity of uninsured depositors by attracting insured depositors, “they come at a price as these banks end up paying higher deposit rates and insurance premiums.” As a result, transparent banks face higher external funding costs as they have to pay higher deposit rates. Consequently, they have to rely more on internally generated funds to support asset growth. That is especially true when some projects on the margin become unprofitable and therefore need more internal funding to become viable, the paper explained.

“The takeaway for regulators is that there is a cost for transparency at banks.” — Itay Goldstein

“Transparency is a mixed bag: It has some positives and some negatives,” said Goldstein. “When transparency is negatively correlated with profitability and positively correlated with funding costs, then you see that there are some undesirable implications.”

In fact, the paper cited a theory which argues that banks should be a little opaque. Goldstein said opacity allows banks to provide more liquidity to their depositors by creating “safe, money-like claims,” which essentially are bank deposits without the uncertainty around the constant revelation of new information.

“When you put your money in the bank, you want to have peace of mind,” he said. That feeling of security vanishes when greater transparency causes all depositors to follow the bank’s performance and financial health, he explained. As a consequence, such opacity keeps depositors happy and results in lower funding costs and higher profitability. One downside, however, of opacity is that it results in “stronger market freezes/credit busts in periods of economic downturns,” the paper noted.

In a nutshell, according to the study’s findings, here are the implications of transparency for banks. When banks are transparent, or score high on the R2 metric, those that report sound financial health attract more uninsured deposits. The opposite occurs in times of poor performance — they see a flight of uninsured deposits. In times of poor performance and a loss of uninsured deposits, transparent banks try to attract insured deposits with higher rates. This transparency allows for more monitoring, but reduces the stability of bank deposits and therefore the safety that uninsured depositors may perceive. Overall, the latter effect is what leads transparent banks to have higher funding costs and lower profitability.

Those pros and cons leave takeaways for regulators. “The takeaway for regulators is that there is a cost for transparency at banks,” Goldstein said. “To the extent that regulators are always pushing for more transparency, they need to be aware that at some point transparency could also be a problem because it makes it more difficult for the bank to perform its key role of providing money-like securities.”