Are banks reducing the risk transparency gap? The effects of the Enhanced Disclosure Task Force report

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Are banks reducing the risk transparency gap?

The effects of the Enhanced Disclosure Task

Force report

Master’s Thesis

Master Accounting & Control

Author:

M. D. (Marijn) Broekhuizen

Studentnumber:

s2606178

Date:

October 1, 2014

First supervisor:

drs. J.L. Bout RA

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Abstract

This thesis investigates the level of voluntary disclosure for European banks, measured by the level of adoption of the Enhanced Disclosure Task Force report of 32 recommendations. After controlling for bank size and banks that have contributed or were a member of the Enhanced Disclosure Task Force, a sample of 15 banks was drawn. First of all an examination is performed regarding whether the Enhanced Disclosure Task Force report enhances current accounting requirements in view of IFRS 7. Afterwards, the level of adoption is measured by use of an index and scoring in four categories for each recommendation. The results of this thesis show that the level of voluntary disclosure has increased but that overall only 49% of the recommendations have been adopted. Subsequently, by use of the Pearson correlation index the correlation was measured in view of bank characteristics that might have influenced the level of adoption of the Enhanced Disclosure Taskforce recommendations, such as bank size in total assets, profitability measured by return-on-equity and whether the bank is listed on a stock market. Regarding bank size in total assets and stock market listing a significant positive correlation was found with the level of adoption of the Enhanced Disclosure Taskforce recommendations. Regarding profitability measured by return-on-equity, a significant negative correlation was found with the level of adoption of the Enhanced Disclosure Taskforce recommendations.

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Chapter 1: Introduction

In the aftermath of the financial crisis, financial watchdogs and the public in general are urging for more transparency and clarity with regard to the financial situation and risk related aspects of banks. Consequently, the lack of confidence and uncertainty of the public in the financial sector as a whole led to de-stabilized market economies and resulted in enormous volatility on global financial markets.

A recent article published by Bloomberg1, addressing very stringent stress testing procedures for banks, confirms the above. In this article the Vice President of the European Central Bank (hereafter: “ECB”), Vitor Constancio was quoted on the performed stress-testing as follows: “the objective is no more doubts about European banks. The balance sheet of European banks will be totally robust and transparent to all investors.” This strong statement is a result of public pressure on the performed procedures and stress tests in 2010 and 2011, which were criticized for failing to uncover weaknesses at banks that later failed.

The goal of the ECB to ensure that the balance sheets will be totally robust and transparent shows that financial reporting is an important aspect to help achieve the required transparency. The disclosure of (financial) information is aimed towards all possible stakeholders such as professional institutions, creditors, governments, investors and other decision-makers. This is especially the case for the banking industry since banks are so intertwined with society. In general, market transparency is considered to be a key mechanism that reduces the information asymmetry among market participants, maintaining the efficiency of the market. In fact, the opacity of markets was blamed for the cause of many recent scandals such as Enron, Worldcom, and Fannie Mae. In such cases, investors and regulators often discover important relevant information too late to take adequate measures to prevent a potential crisis from occurring.

An important tool to increase transparency and decrease information asymmetry by firms is considered to be “voluntary disclosure”. Based on previous research by Francis et al. (2005) and Lang and Lundholm (2000), I argue that when banks increase voluntary disclosures, the level of transparency of banks, as perceived by the public, will increase as well.

1_{“Europe banks face toughest simulated slump in stress test” Article on Bloomberg.com, dated}

25-4-2014 http://www.bloomberg.com/news/2014-04-25/europe-banks-face-toughest-simulated-slump-in-stress-test.html

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To examine the reporting related aspects of the financial crisis the Enhanced Disclosure Taskforce (hereafter: “EDTF”) was formed. The EDTF consists of members of asset management firms, external auditors, credit rating agencies, investors and analysts and several global banks. The EDTF was established at a critical time for the global financial system. Investors’ faith in banks and their current business model are at the lowest in decades. Due to the important role of the financial sector, and in particular banks, in the current society, makes it imperative for the banking sector to rebuild investors’ confidence and trust. Trust being a vital aspect of the future health of the financial system.

The EDTF issued a report on October 29th, 2012, responding to the demand for better (voluntary) risk disclosures to take “a step in the right direction to achieve a sustainable and transparent financial industry”. The difference of the proposed enhanced risk disclosures in the EDTF report compared to the steps taken by international regulators, standard setters and the Financial Stability Board (hereafter: “FSB”), is that the EDTF report is developed among private sector stakeholders as a joint initiative representing both users and preparers of financial reports. As a result of the joint efforts of leading global banks, investors, analysts and external auditors, the EDTF was able to propose certain risk disclosures that were not yet required by applicable accounting standards. Furthermore, these risk disclosures were set up in such a way that these could be implemented in the short-term, particularly in the 2012 and 2013 annual reports.

In this research, the focus is placed on the level of adoption of these voluntary risk disclosures by banks and which bank characteristics may have contributed to the adoption. This study investigates the adoption of the voluntary enhanced risk disclosures for 15 of the leading European banks by determining the level of adoption of the 2013 financial statements and risk report (financial year after the year when the EDTF report was published). The level of adoption of enhanced risk disclosures by 15 of the leading European banks is measured by verifying for the proposed enhanced risk disclosures in the EDTF report, whether these have been incorporated in the financial statements of 2013. Besides this main goal, certain bank characteristics that may contribute to the level of adoption are analyzed. Such as: bank size in total assets, profitability and stock market listing. As a result, the main question of this research is: What influence do the proposed disclosure recommendations included in the EDTF report have on risk disclosures in annual reports of banks, and do bank

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This study adds to current literature regarding voluntary disclosure in the banking industry. Furthermore, this study provides information regarding the value of the EDTF report from an independent perspective (as currently only the EDTF itself has performed progress reviews on the level of adoption of the recommendations) and what the added value is compared to the relevant accounting standard (IFRS 7). The EDTF has performed a progress review for 31 banks by requesting these banks to fill out a self-assessment regarding their level of adoption of the EDTF recommendations. For 17 banks the EDTF has performed a so-called “user review” on only 25% of the enhanced disclosure recommendations. This EDTF user review focuses in depth on these recommendations and aims at verifying whether the respective bank has adopted these. The user review by the EDTF has shown significant discrepancies between the performed self-assessment by the bank and the outcome of the user review by the EDTF. In addition, several banks that have been included in the sample of the EDTF are already members of the EDTF. My study adds to current research, as the coverage of EDTF recommendations in this study is almost 90% instead of the 25% that the EDTF report covers. My study also adds to the EDTF report, as it focuses more in-depth on European banks and controls for banks that have contributed or were a member of the EDTF. Furthermore, the EDTF has voluntarily requested banks to fill out the self-assessment, hence by receiving a reply from the respective bank, the outcome is more likely to be positive than negative in sense of level of adoption of the recommendations, as no gains can be obtained from a self-assessment that is negative – meaning non-compliant with the EDTF recommendations. Furthermore, by performing an independent research on the level of adoption of the EDTF recommendations by European banks, taking into consideration the level of coverage in total assets of the global financial sector, a valuable insight can be provided regarding the willingness of banks to adhere to recommendations regarding voluntary disclosures and whether the joint initiative of the taskforce has initiated a positive trend in increased disclosure of banks.

In the following chapter, the previous literature with regard to the voluntary (risk) disclosures and adoption thereof is examined. Furthermore, the factors that might contribute to the level of adoption are determined and afterwards, the hypotheses are defined in this chapter. In chapter 3, research is conducted regarding the applicable regulations and their effect on the EDTF recommendations. Chapter 4 presents the research design, Chapter 5 examines the results and chapter 6 forms a final conclusion.

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Chapter 2: Literature review and hypothesis development

2.1 Introduction

In this chapter, previous literature with regard to the voluntary disclosure theory and agency theory is examined. Furthermore, this chapter provides several bank characteristics that might, based on previous literature, influence the level of adoption the EDTF recommendations, and hence, might increase the level of voluntary disclosure. Thereafter, the hypotheses are defined based on the aforementioned research.

2.2 Voluntary Disclosure

Based on the following quote, the main goal of the EDTF report is related to the adoption of the proposed voluntary disclosures by banks:

“We believe that the adoption of the recommendations in this report can make a significant and enduring contribution to restoring investors’ confidence and trust in the risk disclosures of banks. However, the ultimate success of this report will be judged on the willingness of large international banks to enhance their risk disclosures proactively by implementing our recommendations.” EDTF report – October 29, 2012.

Currently, the motives and consequences of disclosure regulation in the banking sector are still relatively unknown (Leuz and Wysocki, 2008). Based on several studies, voluntary disclosures have both potentially positive as negative effects for the users of the financial statements. A study of Morris and Shin (2002) suggests that more information, which is publicly reported, could potentially lead to ‘bank runs’2 and as a result destabilize the financial system. This due to the fact that financial statements do not only present fundamental information that is considered to be factual, but also contain other bank related aspects such as movements in depositors. Since depositors are not able to alter the course of the bank, depositors are more likely to provide a signal towards the bank by making a ‘run’ for their money, even though they may have misinterpreted the information. This could result in a snowball effect and consequently, the bank will collapse. This ‘run’ might not have occurred if the financial information was held private. In addition, Gigler et al. (2012) argue that a more frequent disclosure of information could lead to investment choices that are

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inefficient because providing more and more frequent information could open up the door to short-term managerial incentives (e.g. cost-cutting which could give a boost to the next quarter results, but in the long-run will possibly decrease profitability).

On the other hand, Leuz and Wysocki (2008) argue that disclosure regulation provides valuable insights with regard to the credibility of current well-established banks and could furthermore create a more competitive market. Since, by disclosing more valuable information, reputation and a good record need to be substantiated with facts (meaning that facts e.g. financial performance, will need to confirm the good reputation and record, and is not merely perceived as such). Moreover, Holder-Webb and Cohen (2007) argue that additional disclosure can decrease a company’s uncertainty about future cash flows and consequently, decrease a company’s default and bankruptcy risk. This is an important aspect that the EDTF report aims to address in view of banks. By the proposed enhanced disclosures the EDTF is trying to achieve a more transparent banking industry by urging banks to disclose more relevant information with regard to liquidity risks, capital adequacy and risk-weighted assets, market risks etc. In addition, Lang and Lundholm (1993) argue that companies that provide accounting information by use of voluntary disclosures enable financial analysts to obtain a better insight in a company’s fundamentals and overall performance, and as a result financial analysts can issue better and more reliable forecasts. Based on a study by Piotroski et al. (2003), financial analysts play an important role with regard to the estimation of future stock returns. By disclosing more relevant information by banks, financial analysts are able to create a more informed and well-founded forecast, resulting in less stock volatility and a more stabilized financial market in view of the banking sector.

The EDTF report was also written with the view of more (useful) disclosure leading to more transparency in mind, since it stresses the importance of enhanced disclosures by providing more relevant information concerning the business model of banks and the risks banks are facing. According to the EDTF, the current aftermath of the financial crisis and the fact that ‘nobody’ saw this coming stresses the necessity of transparency regarding risks and rewards both in the short and in the long run. Voluntary disclosure and the agency theory

To summarize, the main theories in this research are the agency theory and the voluntary disclosure theory. The agency theory is described by Jensen & Meckling (1976) as a contract under which the agent (management) operates on behalf of the principal (shareholder). The principal is dependent on the information that the agent

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provides, resulting in information asymmetry. Scott (2011) argues that information asymmetry occurs as a result that one party has more information than the other party. Agents can reduce the information asymmetry by increasing the level of voluntary disclosure. Voluntary disclosure is defined by Meek et al. (1995) as “free choices on the part of company managements to provide accounting and other information deemed relevant to the decision needs of users of their annual reports”. Moreover, recommendations by an authoritative code or body are considered voluntary disclosure as well (Hassan & Marston, 2010). This is specifically the case for the EDTF report, which provides recommendations for enhanced disclosures with authority, partly as a result of the broad support and involvement of the financial industry.

After reviewing the relevant theoretical background with regard to voluntary disclosure and the transparency the EDTF reports aims at, the following sub-chapters focus on other factors that might contribute to the voluntary adoption of the enhanced disclosures as proposed by the EDTF. Furthermore, the hypotheses for this research are substantiated with available literature.

2.3 Effects of Bank characteristics on Voluntary Disclosure

Size (in total assets)

As mentioned earlier in this study, important tools for accountability are the financial statements and voluntary disclosures included therein. Several studies have argued that firm size has a positive association with the extent of voluntary disclosure, and therefore has been selected as an independent variable in most of the general voluntary disclosure studies such as Lang and Lundholm (1993), Botosan (1997) and Dumontier and Raffournier (1998). Moreover, Firth (1979) argues that collecting and disseminating information is a costly exercise and possibly larger firms are better able to afford such expense and effort. In addition, large firms tend to collect more data for corporate reports and management reports. Hence, minor additional expenses are required to provide additional disclosure of information. Furthermore, larger companies also tend to have higher information asymmetry as a result of a more diverse ownership, consequently leading to higher agency costs. Firms who are dealing with such circumstances disclose more information to reduce such costs (Jensen and Meckling, 1976). Based on the aforementioned literature I have come to the following hypothesis:

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H1: There is a positive association between bank size (in total assets) and level of compliance with the voluntary enhanced disclosures in the annual report.

Profitability

Available literature often argues that profitable firms will disclose more information to show their strong financial position to attract potential investors (Watson et al., 2002). Disclosing more information by profitable firms may also be an attempt to ensure investors that no information is withheld that may indicate a less rosy performance (Skinner, 1994). On the other hand, the same study of Skinner has shown that firms that are less profitable tend to voluntary disclose information to provide an explanation for the negative performance in an attempt to reassure the market. Overall, results of the majority of studies find evidence that profitable firms disclose more information compared to their less profitable counterparts (Lang and Lundholm, 1993; Watson et al., 2002). Hence, I come to the following hypothesis: H2: There is a positive association between a bank’s profitability and adoption of voluntary enhanced disclosures in the annual report.

Stock market listing

Firms with a stock market listing are, due to their public exposure tightly monitored by governmental bodies and regulators. Information asymmetry also plays a large role for listed firms as a result of a larger and broader shareholder group that tends to price protect themselves against firms that are less transparent in their financial reporting. Qu et al. (2012) argue that listed firms will increase their voluntary disclosures to reduce the information asymmetry and to achieve institutional legitimacy in the stock market. In addition, listed firms would like to ensure the liquidity and stability of stock prices to prevent negative signals that could potentially lead to bank runs. Bischof et al. (2013) argue that with regard to banks that were subject to stress tests, the “decrease of market liquidity (on stock market) is entirely attributable to those stress test participants that did not commit to voluntarily maintaining the disclosures of (sovereign) risk exposure”. As a result of the aforementioned I hypothesize:

H3: There is a positive association between bank’s that are listed on a stock market and adoption of voluntary enhanced disclosures in the annual report.

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Chapter 3: Regulations

3.1 Introduction

This chapter is focused towards the relations between risks as a result of financial instruments and the current regulatory environment and accounting standards. First of all, the definition of a financial instrument will be examined including the recognition and measurement thereof based on IFRS. Secondly, the risks that banks are facing are examined in a broader sense and their reflection in the financial statements. Third, as the Basel Accords plays a large role in, amongst others, capital-adequacy and disclosure requirements of banks, a brief development of Basel requirements is set out as this will provide a better understanding with regard to the EDTF recommendations. Fourth, IFRS 7 will be examined with regard to the disclosure requirements regarding financial instruments. Fifth, an in-depth analysis is performed with regard to the EDTF recommendations and how they were established and finally, the EDTF recommendations compared to IFRS 7 are examined and compared. The below stated figure summarizes the aforementioned:

Figure: The above stated figure shows the overview of this chapter

3.2 Risks that banks are facing as a result of financial instruments

General

As banks balance sheets mainly consist out of financial instruments, it is important to first of all obtain an understanding regarding the definition of a financial instrument. Afterwards, it is important to obtain an understanding regarding the way financial instruments are classified and measured in the financial statements according to IFRS.

Definition of financial instruments according to IFRS

Definition of a financial instrument, recognition and measurement thereof.

Banking risks

Risks that banks are facing as a result of such financial instruments.

Basel Accords

Requirements under the Basel Accords

IFRS 7

Examination of IFRS 7 requirements

EDTF

In-depth analysis of the EDTF recommendations and determining the enhancements compared to IFRS 7

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Thereafter, more insight will be given on the risks that arise as a result of financial instruments and how they affect banks.

Financial instruments according to IFRS Definition

According to IAS 32 and 39, a financial instrument is defined as “any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity”. Common examples of financial instruments as defined under IAS 39 are:

 Cash;

 Demand and time deposits;

 Commercial paper;

 Accounts, notes, and loans receivable and payable;

 Debt and equity securities; and

 Derivatives.

According to IAS 39 a derivative is a financial instrument:

 Whose value changes in response to the change in an underlying variable such as an interest rate, commodity or security price, or index;

 That requires no initial investment, or one that is smaller than would be required for a contract with similar response to changes in market factors; and

 That is settled at a future date. (IAS 39.9) Recognition and measurement

In addition to understanding the definition of a financial instrument, it is necessary to determine how financial instruments are recognized and measured to be able to further elaborate and fully understand risks bank face as a result of these financial instruments.

Initial recognition and derecognition

According to IAS 39, an entity needs to recognise a financial asset or liability in its balance sheet when, and only when, the entity becomes a party to the contractual provisions of the instrument. If the financial asset or liability is not directly linked to the entity by means of a contractual provision, the financial instrument may not be included the balance sheet whatsoever. Derecognition of a financial asset shall only

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be done when (i) the contractual rights to the cash flows from the financial asset expire, or (ii) the entity transfers the financial asset (in conformity with IAS 39.18 and 19) and the transfer qualifies for derecognition in accordance with IAS 39.20. Derecognition of a financial liability shall only be done when the liability is extinguished e.g. when the obligation is discharged, cancelled or expires.

Initial and subsequent measurement

According to IAS 39.43, when a financial asset or financial liability is recognized initially, an entity shall measure it at its fair value plus, in the case of a financial asset or financial liability not at fair value through profit or loss, transactions costs that are directly attributable to the acquisition or issue of the financial asset or liability.

In general financial assets are measured at: “after initial recognition, an entity shall measure financial assets, including derivatives that are assets, at their fair values, without any deduction for transaction costs it may incur on sale or other disposal” (IAS 39). The aforementioned does not apply to the following financial assets as stipulated under IAS 39:

 Loans and receivables and held-to-maturity investments, which shall be measured at amortised cost using the effective interest method;

 Investments in equity instruments that do not have quoted price in an active market and whose fair value cannot be reliably measured and derivatives that are linked to and must be settled by delivery of such equity instruments, which shall be measured at cost.

According to IAS 39.47, subsequent measurement of financial liabilities needs to take place at amortized cost using the effective interest method except for:

 Financial liabilities at fair value through profit or loss. Such liabilities, including derivatives that are liabilities, shall be measured at fair value except for a derivative financial liability that is not directly linked to a quoted price (e.g. a Level 1 input). These shall be measured at cost.

 Financial liabilities that arise when a transfer of a financial asset does not qualify for derecognition or when the continuing involvement approach applies.

 Financial guarantee contracts. After initial recognition, an issuer of such a contract shall measure it at the higher of the amount determined in accordance with IAS 37, and the amount initially recognized less, when appropriate,

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Impairment and uncollectibility of financial assets

According to IAS 39.58, an entity needs to assess at the end of each reporting period whether there is any reason to believe that a financial asset or group thereof is impaired. IAS 39.63 indicates that if there is objective evidence that an impairment loss on loans and receivables or investments has been incurred, the loss is measured as the difference between the carrying amount of the asset and the present value of the estimated future cashflows. Afterwards, the amount of the loss shall be recognised in the profit or loss. With regard to an equity instrument that does not have a quoted price in an active market and is not carried at fair value because its fair value cannot be reliably measured, the amount of the impairment loss is measured between the carrying amount of the financial asset and the present value of estimated future cash flows discounted at the current market rate of return (IAS 39.66).

Risks a bank faces due to financial instruments

The risks that a bank faces should be managed carefully, taking into consideration that a bank applies a large amount of leverage and taking risks is a key aspect of the bank’s business model. Although a lot of risks that bank face are shared by other companies as well, the following risks affect banks in particular; liquidity risk, credit risk, market risk and operational risk (Siskos, 2013). As the regulations under IAS 39 with regard to the initial recognition, subsequent measurement and impairments have been discussed, it is important to examine how the key risks that banks face are disclosed in the financial statements as well. This is done in chapter 3.4 with regard to IFRS 7. In view of this study, which focuses on the relation between IFRS 7 and the EDTF report, operational risk is not in scope as this is not part of IFRS 7. As operational risk is part of the Basel Accords and the EDTF report, a brief explanation of the operational risk is provided hereafter.

Operational risk

Operational risk is a risk category to which every bank and organization is exposed. The Basel || committee defines operational risk as: "The risk of loss resulting from inadequate or failed internal processes, people and systems or from external events." Hence, operational risk is a very broad risk. Banks are therefore permitted by the Basel || committee to adopt their own definition of operational risk. Furthermore, operational risk is incorporated in the capital-adequacy calculation of banks taking

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into consideration the risk-weighted assets. This will be further elaborated in the following paragraph.

3.3 Requirements under the Basel Accords

Basel

As mentioned previously, regulators require banks to maintain a certain level of capital. The specific requirements regarding capital-adequacy and how these are determined, are stipulated in the Basel Accords. The Basel Accords have been created by the Basel Committee, which was established in the mid-80s. The goal of the committee was to provide international regulations for supervision on banks (the committee was officially named “Basel Committee on Banking Supervision”).

Firstly, Basel | was published in 1988 with proposals regarding capital-adequacy. Although the Basel Committee had no actual legal and regulatory powers, the proposals were adopted on a global scale. In Europe the recommendations were adopted by use of the Capital Adequacy Directive (CAD) which was issued in 1990 by the European Commission. Basel | was focused on the fact that banks need to have 8% of the granted loans as equity (with limited use of weighting) and was specifically addressed to credit risk. According to Doff (2004), the Basel Committee did realize that banks face a lot more risks than only credit risk, but they assumed that the capital-adequacy as proposed in its current form was also sufficient to cover these other risks. Along the way it turned out that more focus was required towards market risk, hence in 1996 a market risk amendment was incorporated.

In 1999 the Basel Committee announced that Basel | would be replaced by Basel ||. The reason for this was partly that more tailoring was deemed necessary for the risk-weighted assets3 for different banks. For some banks the capital requirements were deemed too high and for some others to low. To bring about a framework for supervision of banks which was aligned with the actual risks banks are facing, the three-pillar framework was established, as visualized on the following page:

3_{Global banking supervisors based in Basel Switzerland use the concept of risk-weighted assets to}

determine a bank’s minimum capital needs. Risk-weighted assets are computed by adjusting each asset class for risk in order to determine a bank's real world exposure to potential losses. Regulators then use

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Figure: The above stated figure shows the Basel 2 framework based on Basel requirements as stated on www.bis.org.

Pillar 1

Pillar 1 represents the capital requirements with regard to credit-, market- and operational risk. For credit risk there are two approaches possible: a standardized approach and an internal ratings-based approach (foundation or advanced). The standardized approach can be considered an extension of the approach of Basel 1. Where Basel 1 was based on a rather rough approach, the standardized approach enables more risk differentiation. By multiplying the loans granted with a risk-weighting (e.g. by use of ratings of Moody’s) and taking the 8% of this amount for capital-adequacy purposes. The internal ratings-based approach, like the name already indicates, does not make use of external ratings but of internal ratings. This is conducted by use of certain parameters such as Probability of Default (PD), Exposure at Default (EAD) and Loss Given Default (LGD). The difference between the IRB foundation approach and the IRB advanced approach is that with the foundation approach banks estimate the PD, but the regulator provides the LGD and EAD, where the advanced approach all parameters are estimated internally. Furthermore, under Pillar 1 such requirements are set for market risk and operational risk. For market risk this is done by use of the value-at-risk (as explained previously) and for operational risk this is conducted by use of the basic indicator approach, standardized approach or the advanced measurement approach. Regarding the basic indicator approach (BIA) the capital adequacy is determined by use of the average revenues of the bank as a whole. Operational risk will increase as the bank increases. For the standardised

Supervision of banks according to Basel 2

1 Minimum

capital

requirements

2 Supervisory

review process

3 Market

discipline

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approach (SA) the bank is divided into various business divisions or segments and separate risk-weightings are applied (e.g. retail services have less operational risk than for example the structured finance department). The third approach, the advanced measurement approach (AMA), is a combination of internal and external data for which the bank itself can apply judgment for both qualitative as quantitative aspects to determine the level of operational risk.

Pillar 2

Pillar 2 represents an additional qualitative assessment of risk management and focuses on how the supervisor can respond in case the risk a bank takes is deemed too high. Pillar 1 aims at credit risk, market risk and operational risk, where Pillar 2, according to Doff (2004), enables supervisor to stipulate higher capital requirements for ‘other risks’ such as interest risk, concentration risk (risk that for example a bank’s portfolio is aimed to much towards a specific industry or geographic region, increasing potential volatility etc.).

Pillar 3

Pillar 3 regards disclosure requirements for banks regarding risks and risk management. According to Doff (2004) such disclosures will enable relevant stakeholders to monitor a bank and the risks a bank is facing and to determine the risk profile of that bank. Furthermore, the Basel Committee on Banking Supervision has issued a consultative document in which they have performed a review of the Pillar 3 disclosure requirements, dated June 2014. 4 This document proposes several enhancements regarding the Pillar 3 disclosure requirements and has also considered the recommendations as proposed by the EDTF. As also concluded in the Basel Committee’s consultative report, the EDTF recommendations are broader in scope than only Pillar 3, and the recommendations as proposed by the Basel Committee, by comparison, suggests that there are limited areas of duplication between the EDTF recommendations and the Pillar 3 proposals.

Basel |||

In 2010/2011 the Basel ||| accord was approved and is scheduled to be in effect of as 31 March 2019. The third installment of the Basel Accords, according to the Bank for International Settlements aim to:

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 improve the banking sector's ability to absorb shocks arising from financial and economic stress, whatever the source;

 improve risk management and governance;

 strengthen banks' transparency and disclosures.

Basel ||| introduced additional capital buffers adding to the current capital buffers as required by Basel | and Basel ||. Furthermore, Basel ||| introduces as minimum “leverage ratio”5. This ratio needs to be in excess of 3% under Basel |||. Additionally, Basel ||| introduces two liquidity ratios. The “Liquidity Coverage Ratio”, requiring a bank to hold sufficient liquid assets to cover net cash outflows over 30 days, and the “Net Stable Funding Ratio”, to ensure appropriate and sufficient funding over a one-year period.

Summary

To summarize, the requirements as set by the Basel Committee are perceived to considerably contribute to the stabilisation of the banking industry by stipulating requirements in view of capital-adequacy, ability of supervisors to respond to increased risks of banks and requiring disclosure of risks and risk management for relevant stakeholders. Furthermore, the EDTF recommendations are linked to the requirements as set by Basel (specifically Pillar 3) and as also confirmed by current consultative reports as issued by the Basel Committee continuous improvements are necessary to adapt to known and unknown risks.

3.4 IFRS 7

Introduction

In this chapter an overall descriptive overview is given regarding the relevant accounting standards on risk disclosure substantiated with results from previous literature. Furthermore, this chapter examines the purpose and objective of the EDTF report and its link to IFRS 7 by examining in what way the EDTF enhances current reporting standards regarding risks as a consequence of financial instruments. Afterwards, previous literature regarding voluntary disclosure is investigated and the connection with the EDTF report as well. As a conclusion, this chapter gives several bank characteristics that, based on previous research, might influence the extent of

5_{The leverage ratio is calculated by dividing Tier 1 capital (mainly common stock and retained}

earnings) by the bank’s average total assets. Thus indicating the level of equity compared to the total assets.

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voluntary disclosure and level of adoption by banks of the proposed enhanced disclosures in the EDTF report.

Background

According to Woods and Marginson (2004), both financial as non-financial companies make to a large extent use of financial instruments. Furthermore, Gebhart, Reichardt and Wittenbrink (2004) have shown that the market of various types of (exotic) financial instruments has increased rapidly. As a result, due to increasing complexity of financial instruments, the International Accounting Standards Board is of the opinion that the users of financial statements are required to obtain relevant information regarding the exposures and risks as a result of financial instruments. Based on the International Accounting Standards Board, such disclosures will enable stakeholders to form a better-founded assessment regarding the potential risks regarding the future cash flows and current financial position of a bank. As a result, the International Accounting Standards Board decided to improve IAS 30 Disclosures in the Financial Statements of Banks and Similar Financial Institutions and IAS 32 Financial Instruments: Disclosure and Presentation. IFRS 7 was originally issued in August 2005 and applies to annual periods beginning on or after 1 January 2007. In addition, Van Hulle (1993) and Jermakowicz (2004) have shown in their studies that the IFRS, by harmonizing and standardizing the available reporting standards, will lead to increased comparability of the financial statements. Furthermore, IFRS ends the European ‘jungle’ of national reporting standards and reduces the freedom of companies to influence the valuation and determination of operational results in their financial statements (Blanchet, 2002) and (Soderstrom and Sun, 2007).

Scope

IFRS 7 applies to all risks arising from financial instruments (IAS 39) (except those financial instruments as mentioned in paragraph 3 of IFRS 7). Furthermore, the IFRS applies to all entities regardless of the number of financial instruments held, although the level of disclosure varies.

Objective

The objective of this standard is:

1. To require entities to provide disclosures in their financial statements that enable users to evaluate:

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a) the significance of financial instruments for the entity’s financial position and performance; and

b) the nature and extent of risks arising from financial instruments to which the entity is exposed during the period and at the reporting date, and how the entity manages those risks.

2. The principles in this IFRS complement the principles for recognising, measuring and presenting financial assets and financial liabilities in IAS 32 Financial Instruments: Presentation and IAS39 Financial Instruments: Recognition and Measurement.

In this study I will focus on the second objective (1b).

The following figure shows the framework of IFRS 7 (in view of objective 1.b):

Figure: Adapted from S. Pucci and M. Tutino (2013)

Nature and extent of risks arising from financial instruments

IFRS 7 requires a bank to disclose information that will enable the users of its financial statements to determine and evaluate the nature and extent of risks arising from financial instruments to which the bank is exposed at the reporting date. The disclosure requirements of IFRS 7 need to be included in the financial statements or cross-references need to be given from the financial statements to other information, such as a management commentary or risk report. These other statements need to be available without limitations to the users of the financial statements and need to be published at the same time of the financial statements. Below, I will further examine

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the requirements of certain risks that banks are facing as a result of financial instruments and which the Enhanced Disclosure Taskforce also evaluates. Namely, credit risk, liquidity risk and market risk.

Qualitative and quantitative disclosures

IFRS 7 stipulates both qualitative as well as quantitative disclosures regarding the aforementioned risks.

Qualitative disclosures

IFRS 7.33 stipulates that disclosures regarding risks, and especially regarding credit, liquidity and market risks, should cover at least the (i) exposures, (ii) objectives, policies and processes and (iii) any changes in the aforementioned aspects. The disclosure regarding the exposures as a result of risks that a bank is facing should inform users on the nature of the risk and the (financial) exposure. Furthermore, providing information regarding risks and exposures is not sufficient. Disclosing the way the bank acts upon the identified risks by determining objectives to mitigate or accept these risks are imperative. Hence, information needs to be provided regarding policies and processes in place for managing the risk and methods used by the bank how to measure these risks. Also changes on a year-on-year basis need to be disclosed regarding the identified risks and how these risks are managed. This will inform users of the financial statements on whether users need to be concerned due to risks and exposures that have increased or changes in the risk measurement and management approach.

Quantitative disclosures

Regarding quantitative disclosures, IFRS 7.34 requires that qualitative disclosures need to be enriched with a summary of quantitative data about a bank’s exposure to risks at the reporting date. The quantitative information that has to be disclosed needs to be based on information that is internally provided to the highest level within the bank, for example the bank’s board of directors or chief executive officer. Ensuring that the users of the financial statements are fully informed on these risks and therefore, will increase risk transparency for decision-making purposes. In case a bank uses several ways to manage exposure to a certain risk, the banks needs to disclose information by use of method providing the most relevant and most reliable information.

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Furthermore, IFRS 7.34 requires disclosures on the concentrations of risk. Concentrations of risk arise from financial instruments that contain similar characteristics. In addition, these financial instruments are affected by changes in the market or other conditions in a similar fashion. Obviously, determining concentrations of risk requires judgment. Therefore, to form an opinion on the concentrations of risk also the approach to identify such risks needs to be disclosed. Also the description of shared characteristics that identifies each concentration (such as geographical area, currency, market or counterparty) and the exposure in amount needs to be disclosed.

Credit risk

According to IFRS 7, credit risk represents the risk of losses as a result of a borrower’s incapacity or failure to meet contractual obligations. This risk arises in case e.g. a loan has been granted for which the borrower will use future cashflows to repay the loan. The issuer of debt is compensated for the risk of a borrower’s failure to do so by obtaining interest payments. Other activities that may give rise to credit risk include, but are not limited to (IFRS 7.B10): entering into derivative contracts, granting financial guarantees or loan commitments (in which case a bank agrees to issue a certain loan at a future period, which are off-balance-sheet liabilities, as the liability is not yet due). Important to note regarding for example the aforementioned financial guarantees, the maximum credit risk exposure of this guarantee is linked to the maximum amount the bank will need to pay in case the guarantee is called on. This may potentially be significantly more than the bank recognizes as a liability in the balance sheet. Hence, one of the requirements is to disclose the maximum level of exposure of a certain financial instrument. The same applies for loan commitments in case the bank is unable to revoke the loan commitment for cash compensation. The full loan commitment is considered the exposure and not only the short or medium term payment that may be called on.

IFRS 7.36-38 stipulate the aspects that need to be disclosed in order to inform users of the financial statements regarding the credit risks the bank is facing. First of all, the bank needs to disclose the amount that best represents the credit risk exposure as per reporting date excluding the netting of any collateral or similar agreements (IFRS 7.36a). The collateral and other credit enhancements need to be separately disclosed including any impairment (decrease in carrying value of a certain financial instrument) or incurred losses on these collaterals and credit enhancements.

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In case of financial assets that are either past due or impaired, IFRS 7 requires banks to disclose additional information. A financial asset is considered past due when the counterparty has not made a payment at the contractual set time. IFRS defines “past due” as: “a financial asset is past due when a counterparty has failed to make a payment when contractually due”. For example, a bank has entered into a lending agreement that requires that a certain amount of redemption and interest needs to be paid every month. If the following month when the first payment is due no payment is received, the loan is considered past due. This however, does not mean that the interest and redemption will never be paid but it does give rise to possible risks regarding this loan in view of collectability and such. To extend the example, in case the counterparty is unable to repay the loan partially or in full, the loan amount needs to be impaired to properly reflect the estimated value of the loan as included in a bank’s portfolio. IFRS 7.37 stipulates that bank’s need to disclose an analysis of the age of financial assets that are past due as at the reporting date but are not impaired. Furthermore, for financial assets that are impaired as at reporting date, an analysis needs to be provided regarding these financial assets including the factors which the bank has considered in determining that these financial assets are impaired. In addition, for the financial assets that are past due or impaired, a description of collateral held by the bank as a security, including the fair value of the collateral needs to be disclosed. According to Landsman (2007) the fair value is the amount for which the asset can be traded or a liability resolved between well-informed, independent parties willing to conduct the transaction. Furthermore, Louwrier (2003) prefers the market price to represent the fair value. IFRS 13 defines fair value as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date”. The aforementioned disclosures enable users of the financial statements to form an opinion regarding the effective credit risk by examining the past due or impaired loan value with the fair value of the collateral.

With regard to collateral and other credit enhancements (e.g. letter of credit) IFRS requires that in case the collateral and other credit enhancements have been taken into possession or have been called on, the bank needs to disclose the nature and carrying amount of the assets obtained and in case the obtained assets are not readily convertible into cash, the bank needs to disclose its policies for disposing or using the assets in its operations (IFRS 7.38).

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Liquidity risk

IFRS explains liquidity risk as “the risk that an entity will encounter difficulty in meeting obligations associated with financial liabilities that are settled by delivering cash or another financial asset”. IFRS 7.39 provides requirements for disclosing liquidity risks. The requirements include “a maturity analysis for non-derivative financial liabilities (including issued financial guarantee contracts) that indicate the remaining contractual maturities”. Furthermore, a maturity analysis needs to be disclosed concerning financial liabilities in the form of derivatives. As an interrelated aspect also the way the bank manages and monitors the liquidity risk requires disclosure. This will provide users of the financial statements information on not only the current liquidity risks but also how potential future liquidity risks are determined and how current liquidity risks are being managed.

In addition to the aforementioned requirements as set by IFRS 7, a thorough quantitative liquidity risk disclosure need to be disclosed. The quantitative liquidity risk disclosure need to be based on information that is provided internally to key management personnel. Furthermore, the bank needs to disclose how those data, as included in the quantitative liquidity risk disclosure and information used by management, are determined. Aspects that IFRS describes that require disclosure relate amongst others to the potential outflow of cash or other asset due to certain exposures. In addition, the qualitative aspect of these potential outflows of cash or other assets may not be neglected, for instance if the data does not fully justify the likelihood of the occurrence of the outflows of cash or will potentially relate to significantly different amounts than indicated in the data.

With regard to maturity analyses that IFRS 7.39a stipulates, a bank will need to use judgement to determine an appropriate number of buckets or thresholds representing a certain duration or time. These buckets need to be representative for the durations of the derivatives to provide the users of the financial statements with useful insights regarding the maturity of the held derivatives. Furthermore, IFRS 7.39b requires quantitative data for financial derivative liabilities showing the remaining contractual maturities. This will enable the users of the financial statements to determine the timing of the expected cash flows, for example with regard to certain loan commitments which may be called upon at a certain period or interest rate swaps that are linked to a certain financial asset or liability used for hedging purposes for a pre-determined period. Also requires IFRS 7.39a and 7.39b that a bank specifically needs to disclose information in case the counterparty has the option or choice on when an amount is paid. In such a case the liability needs to be placed in the earliest

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period and bucket as per when the amount may be called upon. The same applies to loan installments and financial guarantees. The installments and financial guarantees need to be placed in the earliest bucket as per when the bank may be required to pay the committed (loan) amount. IFRS 7 B11D6 requires that presented amounts regarding gross finance lease obligations, prices specified in forward agreements, gross loan commitments and contractual amounts to swap interest or currencies need to be presented as undiscounted to ensure transparency and prevent estimates in favor of the bank regarding the discounting factor.

As is the case for other risks than liquidity risk as well, IFRS 7 stresses the importance of not only purely providing qualitative and quantitative information regarding the exposure of these risks, but also the approach how management effectively manages the liquidity risk. This enables the users of the financial statements to opine on the risk assessment process and management.

Market risk

The definition of market risk as given by IFRS 7 states: “the risk that the fair value or future cash flows of a financial instrument will fluctuate because of changes in market prices.” According to IFRS, market risk consists of currency risk (fluctuations of future cash flows as a result of foreign exchange rates), interest rate risk (fluctuations of future cash flows as a result of changes in market interest rates) and other price risk. Other price risk is explained as: “the risk that the fair value or future cash flows of a financial instrument will fluctuate because of changes in market prices (other than those arising from interest rate risk or currency risk), whether those changes are caused by factors specific to the individual financial instrument or its issuer or by factors affecting all similar financial instruments traded in the market”.

To provide users of the financial statements with information regarding the exposure of the bank towards the different types of market risk, a bank needs to disclose a sensitivity analysis. Unless the entity complies with IFRS 7.41 (disclosed in the next paragraph), the sensitivity analysis should be drawn up for each type of market risk showing the bank’s exposure to these risks and how these risks would have affected the equity and/or profit or loss if changes in the risk variable occurred as per the end of the reporting period. Due to the various variables that are partly judgmental, it is imperative and stipulated by IFRS 7.40 to disclose the methods and assumptions used in preparing the various sensitivity analyses. Also, for comparative

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purposes, any changes in the approach, assumptions or methods compared to previous period need to be disclosed and explained.

If a bank complies with IFRS 7.41, the aforementioned is not applicable. In that case a bank prepares a sensitivity analysis such as value-at-risk, that reflects interdependencies between the various types of risks and uses that analysis to manage its financial risk such an analysis may be used instead of the separate sensitivity analyses for each type of risk. Nevertheless, the bank needs to disclose how the data and parameters were obtained the assumptions and methods used, and possible limitations to the applied approach. For example, as a bank has certain trading positions, market prices of these positions will fluctuate over time. To provide users of the financial statements an insight regarding the risks related to such trading positions, under IFRS 7, banks are required to disclose an analysis of the value-at-risk. Important components that are used for this analysis are ‘probability’ and ‘time horizon’. The value-at-risk represents the probability that the trading portfolio will not decrease more than the indicated value-at-risk for the mentioned time horizon and the probability. For example, a bank has a one-day 90% value-at-risk of EUR 10 million, such a trading portfolio would be expected to not decrease in value more than EUR 10 million in nine days out of ten. The value-at-risk provides an indication regarding the risk and volatility of the bank’s trading portfolio as a result of market price fluctuations. To summarize, the goal of the requirements as set by IFRS regarding market risk, is to provide the users of the financial statements with the exposures as per reporting date and how these exposures are determined and managed.

3.5 The Enhanced Disclosure Taskforce

Objective

In December 2011, an international meeting for public and private stakeholders in the financial industry was organized by the Financial Stability Board (hereafter: “FSB”) to evaluate the current risk disclosures. The role of the FSB is to coordinate between international regulators and international standard setting bodies. Furthermore, FSB’s goal is to develop and promote e.g. financial sector policies to do anything in its power to preserve financial stability. Discussions (which will be examined further hereafter) during this meeting led to the formation of the EDTF with the following purpose7:

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I. To develop principles for enhanced disclosures, based on current market conditions and risks, including ways to enhance the comparability of disclosures, and;

II. To identify leading practice risk disclosures presented in annual reports for end-year 2012.

Furthermore, the task force was encouraged to involve and communicate with standard-setting bodies, such as the Basel Committee on Banking Supervision and the International Accounting Standards Board (IASB)8.

Considerations of the Financial Stability Board

This paragraph provides more insight regarding the considerations and discussions that contributed to the EDTF recommendations. This is helpful as this partly provides a link between current accounting standards, of which IFRS 7 has already been discussed, and the way forward by use of the EDTF recommendations.

The EDTF preferred risk disclosures requirements that are principle-based rather than rule-based and more standardized disclosure formats to increase comparability. Although principle-based approaches are also included in IFRS 7 (disclosure on financial instruments) greater disclosure need to be given to risks that might emerge from the bank’s activities. In addition, the financial crisis has shown the importance of information regarding risks, the relation between financial instruments and these risks and the implementation of the risk management function (Kellerman, 2009).

The IASB and the FASB also discussed their views on current risk disclosures. They note that improvements have been made regarding e.g. financial instrument risks and off-balance sheet risks, but overall they agreed that further improvement would increase transparency. Furthermore, Watts (1977) and Watts and Zimmerman (1986) conclude that indirect advantages of the improvement of financial statement information are related to the improved usefulness and transparency of these financial statements. For this goal, regulators acknowledge that to achieve the most effective result, regulators, firms and stakeholders need to cooperate and reach out to each other to obtain insights to improve financial report disclosures.

When auditing the financial statements and risk disclosures included therein, external auditors take into consideration the risk of material misstatement. External

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auditors are required to determine whether the risk disclosures are not materially misstated and that other relevant disclosures are consistent with the financial statements as a whole. The difficulty remains for external auditors regarding the auditability of certain disclosures and forward looking information. Furthermore, certain disclosures and/or information supply towards investors and analysts are not subject to an audit by the external auditor. Other difficulties such as materiality concepts and going concern assessments have been taken into consideration as well by the EDTF while examining improvement areas.

According to the EDTF report, investors and analysts stressed the importance of disclosures to create transparency of risks that bank’s are facing. By being transparent in both potential upsides, as downsides will increase trust in the management of banks. Nevertheless, more disclosures are not necessarily increasing transparency. By providing too much irrelevant information, relevant information is being obscured and the disclosures miss their goal. Therefore, “many participants encouraged that disclosure on past risks no longer of key importance should be allowed to be phased out, to ensure more relevant disclosure and avoid unnecessary reporting burden”.

As derived from the EDTF report, the full range of the participants of the meeting - investors, analysts, standard setters, bank experts and auditors – agreed that there is an important need for enhanced disclosures. Participants agreed that the FSB should take an important role in coordinating the establishment of such enhanced disclosures. In addition, the enhanced disclosures should be broad in scope and at least cover the themes as identified during the meeting. As a result, the FSB has set up the enhanced disclosure taskforce of which the EDTF report is the result, proposing recommendations with as main goal to increase transparency and confidence in the financial industry on a global scale.

3.6 IFRS 7 versus the EDTF recommendations

Introduction

This chapter will describe how the EDTF recommendations enhance the disclosures that are already required by IFRS 7. This will be done by making reference to the 32 recommendations as proposed by the EDTF and by examining how these recommendations enhance the specific aspect of IFRS 7. The following section will be divided in the following themes: General, Risk Governance and Risk Management strategies/business model, Capital adequacy and risk-weighted assets, Liquidity, Funding, Market Risk, Credit Risk, Other risks.

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General

Recommendation 1:

The main purpose of this recommendation is to improve navigation throughout the financial statements. Financial statements are often long and contain a lot of detailed (risk) information that for which some users may have difficulty locating. Banks are urged to cluster all risk related information in the financial statements, but in case this is not feasible, clear help needs to be provided by use of an index and/or other references for guidance. IFRS 7 or other standards do not specifically stipulate requirements for improving the navigation through the risk report. This recommendation has been excluded for this study as it has a very general scope.

With this recommendation the EDTF strives to increase clarity regarding the used definitions and the parameter values used. For example, Value-at-Risk disclosures can be enhanced by providing information regarding the assumed confidence intervals or the holding periods. Since, the confidence interval will provide an indication regarding the level of confidence the bank has regarding the estimate (e.g. 95% or 99%) and the holding period will provide more information regarding the time span the value will be at risk. Although IFRS 7.41 stipulates that key parameters need to be disclosed (for instance regarding the Value-at-Risk) and IFRS 7 B20 specifically mentions the holding period and confidence levels, the recommendation does additionally stress the importance of clarifying certain financial instrument related terms and with this recommendation goes a step further. As there is an overlap between the recommendation and the current requirements by IFRS 7, this recommendation has been excluded for this study.

The goal of this objective is to provide users of the financial statements with specific information regarding top and emerging risks. Since users may not be fully aware or able to determine what has changed during the reporting period with regard to the bank’s risk profile, processes or risk models. This recommendation urges banks to provide information regarding these risks and the changes in these risks over time. According to the EDTF an emerging risk may be defined as ‘one which has large uncertain outcomes which may become certain in the longer term (perhaps beyond

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occur’. Furthermore, significant changes in regulatory and accounting requirements are expected in the near future. Banks could inform the users of the financial statements regarding the impact of these future changes for its business strategy, operations and reporting. Although the recommendation stresses the importance of top and emerging risks including these changes in these risks, the recommendation does not differ from requirements as set in IFRS 7. For example, the requirements as set by IFRS 7 (e.g. IFRS 7.33 and 7.34) require specific disclosure on the risks arising from financial instruments, the exposures, objectives and policies on managing these risks and any changes in the aforementioned compared to previous period. This recommendation has been excluded for this study as it has a very general scope and is already (partly) covered by IFRS 7.

This recommendation as been mainly set up as a result of Basel ||| which is currently developing a standardized template for amongst others, the disclosure of leverage ratios. This format including the specific guidance on calculating the leverage ratio is currently still in progress and is expected to be in effect as of January 2015. Since the rules and guidance on determining the leverage ratio is still pending, the EDTF proposes with this recommendation to urge banks to provide users of the financial statements with information on the outline of plans that are in place to follow up on the results of the Basel Committee. Also taking into consideration the possible effects of such capital requirements on the business strategy of the bank.

As this recommendation is highly focused on the banking industry, IFRS 7 does not specifically go into detail on the aspects that this recommendation covers. Hence, this recommendation is considered an addition to the current reporting requirements under IFRS.

This recommendation focuses on the risk management and governance function with a bank. This function will allow a bank to meet the fundamental principles for disclosure, the responsibilities and accountabilities of the risk organisation and how to make sure that the risk management and governance function remains independent from business operations of the bank. In view of IFRS 7, this recommendation is not very different than the requirements as stipulated by IFRS 7. IFRS 7 requires for each indicated risk that an appropriate risk management role, policies and procedures, roles and responsibilities are prescribed and adhered to (e.g. IFRS 7.33b).

Are banks reducing the risk transparency gap? The effects of the Enhanced Disclosure Task Force report