Shuo Zhao (Tilburg University)

Regulatory Model Secrecy and Bank Reporting Discretion

Abstract. This paper studies how banking regulators should disclose the regulatory models they use to assess banks that have reporting discretion. In my setting, such assessments depend on both economic conditions and the fundamentals of banks’ assets. The regulatory models provide signals about economic conditions, while banks report information about their asset fundamentals. On the one hand, disclosing the models helps banks understand how their assets perform in different economic environments. On the other hand, it induces banks with socially undesirable assets to manipulate reports in order to obtain favorable assessments. While regulators can partially deter manipulation by designing the assessment rule optimally, the disclosure decision of the regulatory models remains necessary. The optimal disclosure policy is to disclose the regulatory models when the assessment rule is more likely to induce manipulation and keep them secret otherwise. In this way, disclosure complements the assessment rule by reducing manipulation when it harms the regulators more. These analyses speak directly to supervisory stress tests and climate risk stress tests.