CFA Institute has released a study on the need to improve the quality of financial instrument risk disclosures among financial and non-financial institutions. The study comes at a time when investor vulnerability to the risks of on- and off-balance-sheet items have come to the fore in response to the ongoing sovereign debt crisis and continued fallout from the 2007-09 market crisis.
The study — which addresses credit, liquidity, market, and hedging activities risk disclosures under International Financial Reporting Standards Statement No.7, Financial Instruments: Disclosures (IFRS 7) — is part of a two-volume report. Volume 1 provides a user perspective on financial instrument credit, liquidity, and market risk disclosures, while Volume 2 will offer a user perspective on disclosures of hedging activities.
Why Financial Instruments Risk Disclosures Are Important
The importance of financial instrument risk disclosures as a means of helping investors to understand the risks associated with on- and off-balance-sheet items has been accentuated during the current sovereign debt crisis and the recent global market crisis. Both have highlighted the interconnectedness which exists between the state of the economy and several key financial risk exposures such as credit, liquidity, and market risk. At the same time, there is often limited transparency for users regarding these risk exposures, and how they are managed by reporting entities. This limited transparency contributes to mispricing of risk, misallocation of capital, and reduces investors’ ability to provide market discipline on a timely basis. This limited transparency also contributes to the disorderly capital market correction in the valuation of companies during crisis periods.
In a broader sense, across the full economic cycle, high-quality financial instrument risk disclosures can assist in informing users regarding financial instrument measurement uncertainty. Risk disclosures have the potential to inform investors regarding a reporting entity’s risk profile regardless of the measurement basis (i.e., fair value or amortised cost) applied.
The need to improve risk disclosures, based on the input from investors and other key stakeholders, was noted by the Financial Stability Board (FSB) in a recently issued report:
While standard setting bodies have improved their disclosure requirements since 2008, the Financial Stability Forum (FSF) had also recommended that investors, financial institutions and auditors should jointly develop risk disclosure principles and should work together to identify enhancements in specific risk disclosures that would be most relevant given the recent evolution of market conditions. This has not happened. – Financial Stability Board
The findings and recommendations of the CFA Institute study can, by articulating the investor perspective, contribute to the dialogue on how to improve the quality of financial instrument risk disclosures, as recommended by the FSB.
Our research shows that while risk disclosures are both widely used and regarded as important, users have low levels of satisfaction with these disclosures. The user feedback and company analysis help to explain the low satisfaction, revealing the following shortcomings:
- Risk disclosures are difficult to understand, due to their incomplete nature and often fragmentary presentation.
- Market-risk category is too broad.
- Qualitative disclosures provided are uninformative.
- Users have low confidence in the reliability of quantitative disclosures.
- There is low consistency and comparability of disclosures.
- Top-down and integrated messaging on overall risk management is missing.
Recommendations to Enhance Disclosures
Based upon the noted deficiencies, the report offers the following recommendations:
- An Executive Summary of Risk Disclosures Should be Provided by Companies – This should outline details of entity-wide risk exposure and effectiveness of risk management mechanisms across risk types that are considered to be significant and primary risk categories for specific business models.
- Differentiated Market-Risk Categories – The components of market risk should be differentiated into more specific categories (i.e., interest rate, foreign currency, and commodity). These proposed new categories should be treated with the same level of distinctiveness for reporting purposes as is the case with credit and liquidity risk under IFRS 7.
- Improved Alignment of Qualitative and Quantitative Disclosures
- Standardization and Assurance of Quantitative Disclosures
- Improved, Tabular, and Integrated Presentation of Disclosures – For example, there should be integration of risk exposure and risk management information.
In addition, the study recommends specific improvements on credit, liquidity, and market risk, including the need to provide informative qualitative disclosures; improved and more meaningful sensitivity analysis; meaningful disaggregation of counterparty details to convey concentration risk; and risk information related to off-balance-sheet exposures.
The overarching focus of disclosure improvements should be on defining and implementing principles that enhance both the information content and understandability of disclosures. To that end, CFA Institute has outlined recommendations for improvement. If implemented, these recommendations will result in disclosures that are both more informative and easier for investors to process for securities valuation and analysis purposes.