Following Pillar 3 of the new Basel Capital Adequacy Proposals (Basel II), we analyse the effects of disclosure in the banking sector in a stylised setting of delegated portfolio management. We first consider the interaction between the shareholder and the manager of a bank - the manager has to exert risk monitoring effort in order to decrease the bank's probability of default. Disclosure is captured through a signal about the manager's effort and it is shown that the shareholder desires full disclosure (a perfect signal) so as to implement the first best level of effort. We then introduce a third stakeholder that has fixed claims on the bank, the debt-holder. This agent introduces a counteracting effect: the shareholder may not desire full disclosure anymore given that a lower level of disclosure allows the bank to improve its perceived probability of default, which in turn decreases its financing costs. This implies that subordinated debt itself may not increase the soundness of the banking sector unless it is accompanied by measures of compulsory disclosure.
