Abstract
The general view underlying bank regulation is that bank disclosures provide market discipline and reduce banks’ risk-taking incentives. We show that bank disclosures can increase bank leverage and bank risk. The reason stems from the interaction between insured and uninsured debt. Bank disclosures reduce the agency problem between uninsured debt and equity, thereby lowering the cost of leverage for banks. By issuing uninsured short-term debt that is repaid ahead of insured deposits when economic conditions deteriorate, banks dilute insured deposits. Higher levels of uninsured short-term debt increase the subsidy provided by deposit insurance, which increases banks’ risk-taking incentives. We identify conditions under which this negative leverage effect dominates the standard market discipline effect, so that providing market discipline through bank disclosures increases banks’ risk.
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