Financial Regulatory Transparency and Sovereign Borrowing Costs

Abstract

How do markets discipline governments? The most direct way is through sovereign borrowing costs. Investors charge more interest when they anticipate that the risks of default increase. Where markets get their information from and how they use this information, however, is not well documented. In this paper, we argue that markets consider more than government balance sheets – they also consider the risks of the private financial sector to sovereigns. Investors, in turn, are more confident of their assessments for countries where bank regulators release detailed data on their financial sectors. To test this, we use a Dynamic Hierarchical Bayesian Item Response Theory to create a new, global, and comparable Financial Regulatory Transparency (FRT) Index. The Index is a unique measure of a country’s willingness to release minimally credible data on their financial system through international organizations. Using the FRT, we find that the effects of transparency are not always positive, but are instead conditional on a country’s public indebtedness. While more and increasing transparency lowers borrowing costs for highly indebted countries and countries that are reducing their debt, more transparency can increases the costs and volatility of those costs for countries with rapidly increasing debt.