An investigation into the opacity of the banking industry

The opacity of the banking industry, long cited as one reason for regulating banks, has received renewed attention due to the financial turmoil induced by the subprime mortgage and credit crises that began in 2007. Consequently, understanding the sources of opacity in banks and the impact opacity has on the market's ability to accurately assess value remains highly relevant for our understanding of financial fragility. The purpose of this dissertation, which consists of two related essays, is to improve our understanding of the manner in which opacity may affect the value of a bank. The first essay is a detailed investigation of assets that contribute to the opacity of banks. The second examines the extent to which the opacity of a bank impacts the price discovery process in equity markets.;The second essay examines industry repricing occurring as a consequence of bank merger announcements. Specifically, I investigate how merger announcements in the period 2000 through 2006 affect the valuation of other banks not involved in mergers. My results suggest that a merger announcement conveys positive information to the market about the value of other industry banks. There is an overall upward revision in bank value and, most importantly, the repricing is higher for those industry banks that have larger investments in opaque assets. The findings are robust to the inclusion of potential competitive and spillover effects that may be associated with a merger. I also examine to what degree opacity influences the reversal of bank values that occurs from January 2007 through June 2008. The evidence shows that the industry banks which benefited the most from mergers in 2000-2006 also experienced the largest losses from the credit crisis that followed, demonstrating how opacity can create volatility that increases the fragility of the financial system.;In the first essay, I show that the opacity of a bank, as reflected by its asset composition, influences equity charter (market) value. In particular, I find that investments in opaque assets are more profitable and yield higher expected returns than investments in transparent assets but also create higher systematic and idiosyncratic risks than transparent assets. Using the concept of residual income valuation to control for the effect of profitability on charter value, I find that investments in opaque assets reduce equity charter values. Moreover, the magnitude of the information uncertainty discount associated with opacity varies over time. The evidence indicates that the cost of opacity was near its lowest level at the end of 2001-2006 and increased significantly throughout 2007.