FRANKFURT, Sept 1 (Reuters) - Banking supervisors should withhold some information when they publish stress test results to prevent both bank runs and excessive risk taking by banks, according to a paper co-authored by a Bundesbank economist.
European banking authorities are due to carry out a fresh round of stress tests next year as they try to restore investor and depositor confidence in the continent's banks after the financial crisis.
The paper, presented at a conference in Mannheim last week but yet to be published in its current form, says stress tests should be used to influence depositor behaviour and warns against giving too much away.
If depositors know from the watchdog that banks are in trouble, they will withdraw their cash, threatening lenders' survival and causing the panic the supervisor is trying to avoid, the paper said.
For this reason, the authors say, the amount of information disclosed by supervisors should decrease the more vulnerable the banking sector is expected to be.
"The optimal level of 'informativeness' ... depends on the objective probability that the banking sector is vulnerable," authors Wolfgang Gick, from the Free University of Bozen, and Thilo Pausch, an economist with the Bundesbank, wrote.
"As we find, the higher the latter probability, the less informative the optimal disclosure mechanism should be designed."
But giving banks a clean bill of health also carries risks, according to Gick and Pausch, by encouraging depositors to leave their money in banks. That would undermine market discipline and lead lenders to take excessive risks, they wrote.
For that reason, supervisors should always keep depositors on their toes by maintaining a degree of uncertainty about the health of banks, the paper concludes.
"By introducing a fully-revealing stress test mechanism, a supervisor would induce extreme volatility concerning depositor behavior in the banking system ... which is clearly not optimal," Gick and Pausch wrote.
"The optimal stress-testing mechanism will leave depositors with some amount of residual uncertainty."
Richard Reid, a research fellow in finance and regulation at the University of Dundee, agreed that giving extensive details could lead to even bigger problems and rob regulators of a window to rectify problems, or make it harder for policymakers to deal with wider issues like sluggish growth.
"It's an age-old problem for regulators, how much transparency there should be," Reid said. "There is an argument of 'let's flush it out,' but in the current situation the weak upturn is a key concern to central bankers, and if you spook markets about banks, then it might further complicate the provision of credit to the economy."
The European Central Bank declined to comment on the paper. The Bundesbank could not immediately be reached for comment. (Reporting By Francesco Canepa, additional reporting by Huw Jones, editing by Larry King)