The need for better risk disclosures has been evident throughout the financial crisis. From the standpoint of investors and bank counterparties, the ongoing high cost of borrowing alongside difficulties that many banks still face when accessing different funding markets reflect the opacity surrounding bank institutions’ risk profiles. In this respect, the formation of the Enhanced Disclosure Task Force (EDTF) — a private sector initiative mandated by the Financial Stability Board (FSB) to recommend ways of enhancing existing risk disclosure within financial reports — was highly welcome.
The EDTF, which was formed during the first half of this year, began its review in May 2012 and made recommendations in an FSB-issued report on Enhancing the Risk Disclosures of Banks. The EDTF report, issued on 29 October, encourages large banks to improve communications around their key risks and makes recommendations that are both implementable by banks and useful to investors. If the EDTF recommendations are adopted, the quality of risk reporting within banks’ financial reports will be strengthened.
An article by PIMCO Managing Director of Credit Research Christian Stracke, who also co-chaired the EDTF, affirms the particular difficulties that both general and specialist banking-sector bond and equity investors face when analysing banks. He observes that investors tend to see banks as opaque black boxes where risks are still poorly disclosed or — worse — actively obscured by management. He further observes that the opacity of banks is likely a contributing factor in the high cost of borrowing, evidenced by significant credit spreads whereby many banks still pay anywhere from 50% to 100% more in credit spreads relative to similarly rated industrials. He notes that investors have several questions when seeking to understand precisely what they are investing in, but these questions remain difficult to answer for many banks. These questions include:
- What are the loans and securities on a bank’s balance sheet?
- What is their quality? Where do they come from?
- What is their collateral, and what were the lending standards when the loans were made?
Even more important:
- What exactly are the liabilities of a bank and corresponding maturity periods?
- And are those liabilities secured or unsecured, and if secured, then secured by what assets?
- What are the various other market and operational risks that a bank faces?
Given the above noted opacity of many banks, the EDTF formation and its recommendations is a timely initiative.
EDTF Composition and Development of Recommendations
The EDTF was comprised of senior representatives from banking institutions, audit firms, bank equity and fixed income investors from leading investment management houses, and different investor organisations including CFA Institute. The EDTF recommendations were developed with task force members divided into work streams across key six risk areas, including risk governance and how business models contribute to risk; capital adequacy and risk-weighted assets; credit risk; liquidity and funding; market risk; and other risks.
Recommendations were developed over several months based upon a comprehensive review of existing disclosure practices amongst large global banks, identifying user information needs and extensive review of existing risk-reporting-related studies. Through four in-person meetings of task force members spread over five days, recommendations were extensively reviewed and debated to ensure that all could be implemented by the banks and also be useful to investors.
Key Findings of the Enhanced Disclosure Task Force
The EDTF report articulates principles that aim to improve comparability and enhance the understandability of risk disclosures and at the same time enhance key areas of current information deficiencies within these disclosures. The EDTF addresses several shortcomings highlighted in a 2011 CFA Institute study on risk disclosures. Our report showed that while users of financial reports considered risk information important, they were dissatisfied with existing risk disclosures within financial reports due to their low comparability and inconsistency across reporting entities. Users also indicated that risk disclosures often did not include key information and were difficult to understand.
The EDTF report generally emphasizes communication rather than compliance by reporting banks. Such an emphasis corresponds with one of the key overarching recommendations made in our 2011 report. The EDTF report makes over 30 specific recommendations focused on the six key risk areas that were addressed. The recommendations touch on several aspects of significant deficiencies including improving disclosures of encumbered assets, risk-weighted assets and capital adequacy, and impairments of renegotiated loans. For example, it is currently quite difficult to discern the level of encumbered assets across specific banks- although such an understanding is crucial for fixed-income investors and bank lenders. Banks that hold a high level of encumbered assets are riskier to capital providers than those that do not.
Further to its recommendations, the EDTF report also delineates a number of existing leading practice disclosures among reporting banks and illustrates what desirable best practice disclosures should look like. The best practice illustrations can help facilitate effective implementation by banks.
Investors Can Have a Role in Encouraging Better Disclosures
The fundamental disclosure principles and specific risk disclosure enhancements of the EDTF are highly relevant because they are heavily informed by the input of banking sector specialists and the development of the recommendations placing significant emphasis on ensuring that user information needs were being met. Investors will be well served if all major global banks adopt the enhanced risk disclosure recommendations contained within the EDTF report.
The crucial next step is for investors who follow particular banks to continue to push for high quality disclosures. Investors and analysts can achieve this by communicating to bank management the need for information required to fully understand a reporting bank’s risk profile. Such a push will allow the improved disclosure of information that enables investors to have a better understanding of the risk profile of reporting banks and to more effectively allocate capital.