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Session on Information and Session on Information and TransparencyTransparency

Discussion Discussion byby

Edward J. KaneEdward J. Kane

Boston CollegeBoston College

September 15, 2006

6th Annual FDIC-JFSR Research Conference6th Annual FDIC-JFSR Research Conference

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Central Issue: How Do Changes in Accounting Central Issue: How Do Changes in Accounting

Rules Affect Financial Institutions?Rules Affect Financial Institutions?

Does Enhanced “Accounting Disclosure” Does Enhanced “Accounting Disclosure” Increase Increase TransparencyTransparency and and StabilityStability? ?

Because the Degree of Information Asymmetry Because the Degree of Information Asymmetry is a Managerial Decision Variable, Does is a Managerial Decision Variable, Does Expanding Disclosure Requirements Merely Expanding Disclosure Requirements Merely Force Malevolent Insiders (Where They Exist) to Force Malevolent Insiders (Where They Exist) to Hide Threaded Needles of InformationHide Threaded Needles of Information Inside Inside an Even an Even LargerLarger Haystack of Disinformation? Haystack of Disinformation?

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II. . Paper by Rocco HuangPaper by Rocco Huang Huang focuses Huang focuses primarilyprimarily on: the on: the correlationcorrelation between between

two proxy indices: two proxy indices: 1. Nier’s 17-variable index of a firm’s 1. Nier’s 17-variable index of a firm’s

accounting informativeness (AI)accounting informativeness (AI). . 2. LLorente, Michaely, Saar, and Wang’s index of 2. LLorente, Michaely, Saar, and Wang’s index of

private information trading (PIT)private information trading (PIT). . And on how these variables correlate with And on how these variables correlate with bank-specificbank-specific

variables variables and country-level indices of and country-level indices of supervisory supervisory powerpower (SP)(SP). .

Omitted VariablesOmitted Variables: No consideration of country-level : No consideration of country-level measures of supervisor’s measures of supervisor’s enforcementenforcement technology technology or or imposed imposed legal penaltieslegal penalties for violating focal laws and for violating focal laws and regulations. [Example of token $1 fines for exceeding 55 regulations. [Example of token $1 fines for exceeding 55 mph in Montana in 1970s and early 1980s.]mph in Montana in 1970s and early 1980s.]

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MODELLING ISSUESMODELLING ISSUES

1. Only PIT is modelled as an 1. Only PIT is modelled as an endogenous variableendogenous variable; ; AI and SP are not. AI and SP are not.

2. PIT is the 2. PIT is the output of a prior regressionoutput of a prior regression , so it has , so it has its its own error termown error term. (PIT is the “slope shifter” in a . (PIT is the “slope shifter” in a regression of the form: regression of the form:

y = a + (b + cV)x + u. y = a + (b + cV)x + u. Because coefficient standard errors are Because coefficient standard errors are understated, understated, conventional t-values greatly conventional t-values greatly overstate the true significance of such overstate the true significance of such variables. variables.

3. PIT is aggressively interpreted. 3. PIT is aggressively interpreted. More simplyMore simply, it is a , it is a measure of market measure of market liquidityliquidity per seper se. .

4. Especially where insider trading is illegal, insiders 4. Especially where insider trading is illegal, insiders would be smarter to do their trading in would be smarter to do their trading in credit credit default swapsdefault swaps and other derivatives markets. and other derivatives markets.

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Sampling and Interpretation IssuesSampling and Interpretation Issues

1. 1. RepresentativenessRepresentativeness: What is the statistical population? : What is the statistical population? Inclusion in Datastream and the benign macroeconomic Inclusion in Datastream and the benign macroeconomic era of 2003-2005 limits reach of findings. era of 2003-2005 limits reach of findings.

2. 2. Potential Heckman BiasPotential Heckman Bias: Most country-level variables : Most country-level variables may be conceived as resulting endogenously from may be conceived as resulting endogenously from sectoral bargaining in the political economy. sectoral bargaining in the political economy.

Given his marginal t-values, the author should test Given his marginal t-values, the author should test for this directly. For example, for reverse for this directly. For example, for reverse

causation causation from AI to SP. from AI to SP. • The deeper policy question is not only “Why does society The deeper policy question is not only “Why does society

regulate banks?”, but also “Why do banks in a given regulate banks?”, but also “Why do banks in a given country permit themselves to be regulated and in country permit themselves to be regulated and in particular ways?” particular ways?”

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NIER PaperNIER Paper Uses a Uses a partly largerpartly larger and and partly smallerpartly smaller dataset than dataset than

Huang. Huang. 1.1. More banks (550)More banks (550)2.2. More years (1994-2000), but no overlapping. More years (1994-2000), but no overlapping. 3.3. Fewer countries (32). Fewer countries (32). Huge sample sizes (N = Huge sample sizes (N =

upwards of 2500) raise issue of Lindley Paradox. upwards of 2500) raise issue of Lindley Paradox. • Same 17-Variable Disclosure Index (AI) as Huang.Same 17-Variable Disclosure Index (AI) as Huang.• Endogenous variable is a zero-one Endogenous variable is a zero-one “individual-bank “individual-bank

crisis indicator”crisis indicator” c(i, t). c(i, t). Crisis is defined as a stock return in the 5% lower Crisis is defined as a stock return in the 5% lower trail of the distribution of annual equity returns across trail of the distribution of annual equity returns across all banks and years in the sample. all banks and years in the sample.

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Probit ModelProbit Model**of c(i, t)of c(i, t)

Pr[c(i, t) = 1] is made a function of selected: Pr[c(i, t) = 1] is made a function of selected: 1. Macroeconomic Variables1. Macroeconomic Variables2. Bank-Level Variable2. Bank-Level Variable3. Structural Variables3. Structural Variables a. Transparency (lagged AI)a. Transparency (lagged AI) b. Deposit-Insurance Characteristicsb. Deposit-Insurance Characteristics4. Time Trend4. Time Trend** Hazard models could handle trends better. Hazard models could handle trends better. [5. Endogeneity of AI is Investigated in a Two-[5. Endogeneity of AI is Investigated in a Two-

Stage Framework. Evidence of Simultaneous- Stage Framework. Evidence of Simultaneous- Equation Bias Emerges: Equation Bias Emerges: Negative Coefficient Negative Coefficient Assigned to AI Becomes Almost Twice as Assigned to AI Becomes Almost Twice as Large!!] Large!!]

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AI Has Negative SignAI Has Negative Sign Unlimited Deposit Insurance Coverage Has a Unlimited Deposit Insurance Coverage Has a

Positive SignPositive Sign

Main CriticismMain Criticism: : Need to remove simultaneous-equation bias. Need to remove simultaneous-equation bias.

Not only has AI and DI coverage been shown to be Not only has AI and DI coverage been shown to be endogenous, but Hovakimian, Laeven, and a third author endogenous, but Hovakimian, Laeven, and a third author (JFSR, 2003; 390 banks, 56 countries, 1991-1999) show via (JFSR, 2003; 390 banks, 56 countries, 1991-1999) show via a Heckman model that it is important to allow for the a Heckman model that it is important to allow for the endogeneity of DI design features and link them to country endogeneity of DI design features and link them to country characteristics before concluding anything about their characteristics before concluding anything about their effects on bank-level variables. effects on bank-level variables.

Main Findings:

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Additional CriticismsAdditional Criticisms

1. Need to set tougher significance levels for 1. Need to set tougher significance levels for samples of this size.samples of this size.

2. Need to investigate the 2. Need to investigate the waste of stock-waste of stock-price informationprice information built into the indicator built into the indicator definition. Could try to explain GARCH-definition. Could try to explain GARCH-type models of return volatility instead. type models of return volatility instead.

3. Need to do more with simultaneity. 3. Need to do more with simultaneity.

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Beatty PaperBeatty Paper Focuses on two 2003 changes in the Accounting Focuses on two 2003 changes in the Accounting

Treatment of Treatment of oneone Instrument: Instrument: Trust Preferred Trust Preferred Securities (TPS)Securities (TPS). .

This instrument was invented specifically for This instrument was invented specifically for banks as a device to lighten tax and regulatory banks as a device to lighten tax and regulatory burdens from capital requirement. burdens from capital requirement.

By itself, the first accounting change firmed up By itself, the first accounting change firmed up the the legality of the tax benefitlegality of the tax benefit. .

NeitherNeither change altered the change altered the regulatory benefitregulatory benefit. . Issue: Did Accounting Change in How TPS Issue: Did Accounting Change in How TPS

Were Reported Affect Future TPS Issuance? Were Reported Affect Future TPS Issuance?

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Two Kinds of Statistical TestsTwo Kinds of Statistical Tests

1.1. Differences in MeansDifferences in Means of Two-Year “Issuance Indicator” Before of Two-Year “Issuance Indicator” Before and After the Accounting Change For Subsamples of BHC That and After the Accounting Change For Subsamples of BHC That Fall on One Side or Another of Selected Conditioning VariablesFall on One Side or Another of Selected Conditioning Variables

a. a. Sample CompositionSample Composition: Pre-Change N : Pre-Change N Post-Change NPost-Change N

b. b. ResultsResults: Many differences are significant : Many differences are significant onlyonly in the pre-period. in the pre-period.

2. 2. Aggregate Probit Regression Aggregate Probit Regression of indicator on Predetermined of indicator on Predetermined Conditioning Variables, With Slope-Shifts For Post-Period. Conditioning Variables, With Slope-Shifts For Post-Period.

a. Sample included 905 issuances and 10,449 non-issuances. a. Sample included 905 issuances and 10,449 non-issuances.

b. b. ResultsResults: Three-slope dummies are significant: Public debt and : Three-slope dummies are significant: Public debt and negative-tax positive. Four others are not significant. negative-tax positive. Four others are not significant.

Issuances: 806 107

Non-Issuances: 1,314 1,475

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Criticism: Post Hoc Ergo Proper HocCriticism: Post Hoc Ergo Proper Hoc

The paper produces evidence of The paper produces evidence of a regime a regime change in issuancechange in issuance. However, it does . However, it does notnot show: show: 1. That there is 1. That there is exactly exactly oneone regime change and regime change and

that 2003 is the that 2003 is the best place to locatebest place to locate the the switching point. switching point.

2. Whether 2. Whether other changesother changes in bank or investor in bank or investor environments (e.g., the effects of other tax environments (e.g., the effects of other tax and regulatory events) might help to explain and regulatory events) might help to explain the shift. the shift.