The Effect of Corporate Transparency on Bank Risk-taking and Banking System Fragility

We show real effects of financial reporting transparency on the domestic banking sector. Transparent financial reporting facilitates non-financial firms’ access to arm’s-length financing from external capital markets and foreign banks. This diminishes non-financial firms’ reliance on domestic banks for their financial services. Domestic banks thus face increased competition from the alternate providers of financing and are expected to react as follows. First, domestic banks take on more risk and reduce their cost structure. Second, corporate transparency enhances bank development by forcing banks to research and identify profitable ventures. Third, the overall effect of these activities is to lower the likelihood of a banking crisis in countries with greater corporate transparency. Additional tests suggest that risk-taking is channeled more through non-lending than lending activities, pointing to the beneficial role of diversification in reducing bank fragility. Tests using the mandatory adoption of International Financial Reporting Standards (IFRS) as a shock to corporate transparency indicate that endogeneity is unlikely to be driving our findings. A difference-in-differences design shows that bank risk-taking, cost efficiency and bank development in IFRS adopting countries are more salient than those in non-adopting countries. Overall, the evidence suggests corporate transparency promotes vibrancy and stability in the domestic banking sector.