During the recent crisis we have observed how very liquid, highly rated financial assets all of a sudden became "toxic assets", how ratings for structured products had to be continuously downgraded, how several markets such as, e.g., the interbank market, broke down, and how banks faced severe liquidity and funding problems. Information problems were at the heart of many of these problems. The opacity of structured products, which was no issue in the boom, turned into a major drawback in the crisis; credit ratings were no longer trusted as providing reliable information about default risks; banks’ reported losses were viewed with suspicion by investors.
The decision to relax accounting rules in response to public and political pressure was welcomed by the banks but viewed with suspicion by many investors as an attempt to restrict the quality of information. In contrast, the stress tests conducted by banks that were made public constitute an attempt to improve the quality of information available. These stress tests were quite successful in restoring investors’ confidence in the US, but less so in Europe. It is important that stress tests are reliable as any doubt about their credibility undermines their effectiveness.
The crisis experience has changed our view of information transmission, transparency, and market discipline and raised a number of important questions both at the academic and at the policy level on how to improve transparency.
The first general question that is important to address is how information reaches the market both in normal times and during a crisis, because in order to improve transparency and efficiency it is not sufficient to merely increase the provision and disclosure of information. One of the points we emphasize here is that it is important to distinguish between disclosure and transparency. We interpret disclosure as an act of providing information on behalf of firms and issuers.
Important characteristics of the level of disclosure are the timeliness, reliability, and comprehensiveness of information. In contrast, we argue that transparency arises when the disclosed information is effective in reaching the market and being adequately interpreted. For a given level of disclosure, transparency depends on investor’s information processing capability, behavioural biases, and information needs. Thus, disclosure is a necessary but not a sufficient condition for transparency in the information transmission process.
