Banks: Parallel Disclosure Universes and Divergent Regulatory Quests

Legal and economic issues involving mandatory public disclosure have centered on the appropriateness of either Securities and Exchange Commission (SEC) rules or the D.C. Circuit review of SEC rule-making. In this longstanding disclosure universe, the focus has been on the ends of investor protection and market efficiency, and implementation by means of annual reports and other SEC-prescribed documents.

In 2013, these common understandings became obsolete when a new system for public disclosure became effective, the first since the SEC’s creation in 1934. Today, major banks must make disclosures mandated not only by the SEC, but also by a new system developed by the Federal Reserve and other bank regulators in the shadow of the Basel Committee on Banking Supervision and the Dodd-Frank Act. This independent, bank regulator-developed system has ends and means that diverge from the SEC system. The bank regulator system is directed not at the ends of investor protection and market efficiency, but instead at the well-being of the bank entities themselves and the minimization of systemic risk. This new system, which stemmed in significant part from a belief that disclosures on the complex risks flowing from modern financial innovation were manifestly inadequate, already dwarfs the SEC system in sophistication on the quantitative aspects of market risk and the impact of economic stress.

My new article, Disclosure Universes and Modes of Information: Banks, Innovation, and Divergent Regulatory Quests (forthcoming in Yale Journal on Regulation, vol. 31, no. 3, 2014), is the first work to systematically analyze this new morphology of mandatory public information, a morphology that spans two parallel regulatory universes with divergent ends and means. In addition, the new article shows that both disclosure systems largely rely on a single, longstanding mode of information that a June 2012 article—Too Complex to Depict? Innovation, “Pure Information,” and the SEC Regulatory Paradigm—suggested is insufficient to meet the challenges posed by financial innovation. The 2014 article extends the prior work’s conceptual framework for “information” and, collectively, the research shows the need to not only improve implementation of the traditional “descriptive mode” (i.e., intermediary depictions” of objective reality) but also to systematically deploy the “transfer mode” (i.e., transmittal of “pure information” about objective reality) and the “hybrid mode” (i.e., provision of “moderately pure information”).

This post focuses on the 2014 article’s “disclosure universes” aspects, and leaves aside its “modes of information” aspects (including the update of the June 2012 work’s preliminary analysis of the 2012 JPMorgan Chase “London whale” credit derivatives debacle).

The primary ends of the bank regulator disclosure system reflect its origins. The system’s core component is rooted in efforts centered in Basel that go back to a 1988 accord on bank capital adequacy and, more immediately, a 2004 framework recognizing the potential of market discipline in promoting the soundness of individual banks and the financial system. In the U.S., the first stage of implementing the Basel public disclosure aspects became effective in 2013, and centered on market risks. In 2015, the second stage will cover certain capital adequacy-related matters, including credit risk. The third stage will cover liquidity. A second component of the bank regulator system is an artifact of the Dodd-Frank Act. Under the implementing rules, beginning in 2013, certain financial institutions must publicly disclose various “company-run” stress test results.

As for regulatory means, the general and specific functional elements also diverge from the SEC’s. In terms of general elements, both the required quantum of information and enforcement mechanisms differ. The bank regulator system’s quantum involves the investor-oriented “materiality” standard used by the SEC (i.e., TSC Industries v. Northway) diluted somewhat to accommodate the interests of the banking entity itself. With the bank regulator system, private enforcement is not likely to be possible.

In terms of specific elements, the bank regulator system reflects, among other things, far more sophistication about modeling and its limitations. As to Value at Risk (VaR), for instance, the SEC’s market risk rule (Regulation SK, Item 305) allows wide latitude as to how VaRs are calculated (e.g., models and assumptions) and reported (e.g., confidence levels and time horizons) and requires little information on the validity of the methodology used. Among other things, cross-bank comparisons are thus very difficult. Bank regulators require models to meet specified standards (and be approved), VaRs to be reported at a 99% confidence level with a 10-business-day holding period, and extensive evidence as to the quality of the methodology.

Beyond the contours of disclosure requirements, there are overarching structural issues. At the end of the three-stage U.S. implementation, the Basel-related requirements will apply to market risk, credit risk, and liquidity—i.e., most bank risks. This is a vast domain that is—and prospectively—also fully subject to the SEC disclosure system.

Two sets of regulators with widely divergent ends now explicitly have full authority over the same informational territory as a formal matter. In the long run, the structure of the new morphology of public information may be unsustainable. As bank regulators extend their regulatory march to cover disclosure requirements to capital adequacy and liquidity risks, the bank regulator system might, in effect, come to dominate public disclosure as to bank risks. The chances of this increase if the SEC does not quickly modernize its risk disclosures. The SEC has not revised its market risk rule since its adoption in 1997. The SEC’s industry guide for bank holding companies was adopted in 1976, and has remained largely unchanged even as epochal changes in the nature of banking, financial products, and risk analysis have occurred.

However, when the SEC modernizes its risk requirements, the chances of conflict with bank regulators increase. The regulatory objectives of the two systems not only diverge, but sometimes conflict. A disclosure the SEC system deems essential for investor protection and market efficiency can be contrary to the bank well-being and system stability goals of the bank regulator system (and of the Financial Stability Oversight Council). There may be incoherence in the overall morphology.

In the short run, interim measures such as boundary-setting—and promoting “informational neutrality” of judicial review of rule-making across disclosure systems—might be useful. In boundary-setting, one possible strategy for a synergistic relationship between the two disclosure universes would be to slice risk along quantitative/qualitative lines. Bank regulators, with their comparative advantage in quantitative matters, could focus on risk disclosures of a quantitative nature. The SEC, with its comparative advantage in qualitative matters, could focus on risk disclosures of a qualitative nature (e.g., changes to the “Management’s Discussion and Analysis”).

The full text of the 2014 and 2012 articles are available here and here.