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Master Thesis
Risk Disclosure Practices of the European Banking Sector
Evidence from the 2007 Annual Reports
Author:
Jaap-Willem Don (288497)1
Date:
14 August 2010
Executive summary: Since the financial crisis, there has never been so much attention towards risk
disclosure by financial companies. It is important that stakeholders receive relevant information to
reliably assess the risk profile of a company. This study investigates risk disclosure practices of 40
sampled banks in the European banking sector by analysing the risk information and discussing its
nature. The study reveals an increase in risk disclosure compared to earlier studies, indicating that
risk disclosure practices has been improved. However, the usefulness is still questioned as the
information is mainly qualitative, neutral and biased towards the past. Furthermore, this study
relates the extent of risk disclosure to firm specific characteristics as size, profitability, leverage,
multiple listing statuses and governance structures. However, only size has been found significant in
explaining the variation in risk disclosure.
Keywords: risk disclosure, annual reports, banking sector, European Union
Master: Accountancy, Auditing and Control
Erasmus School of Economics, Erasmus University Rotterdam
Supervisor: drs. R. van der Wal RA
Co-reader: ....
1 E-mail address: jaapwillemdon@live.com
Table of contents
1 Introduction............................................................................................................................4
1.1 Prologue.................................................................................................................................41.2 Research question..................................................................................................................51.3 Sub questions.........................................................................................................................61.4 Relevance...............................................................................................................................61.5 Structure.................................................................................................................................7
2 Institutional Framework..........................................................................................................8
2.1 Introduction............................................................................................................................82.2 The annual report...................................................................................................................82.3 Accounting standards.............................................................................................................9
2.3.1 IFRS.................................................................................................................................92.3.2 IFRS 7 Financial Instruments: Disclosures.....................................................................102.3.3 Regulatory risk reporting..............................................................................................11
2.4 Basel Accords........................................................................................................................122.5 Banking supervision..............................................................................................................13
2.5.1 EMU..............................................................................................................................142.5.2 Central Bank and Financial Authorities.........................................................................14
2.6 Regulation and supervision and the credit crunch...............................................................142.7 Corporate governance codes................................................................................................152.8 Conclusion............................................................................................................................17
3 Theoretical Framework.........................................................................................................19
3.1 Introduction..........................................................................................................................193.2 Positive Accounting Theory..................................................................................................193.3 Agency theory.......................................................................................................................203.4 Stakeholder theory...............................................................................................................213.5 The role of disclosure...........................................................................................................223.6 Efficient market hypothesis..................................................................................................233.7 Risk and risk management....................................................................................................243.8 Banks and their (specific) risks..............................................................................................263.9 Risk disclosure: development and discussion.......................................................................273.10 Conclusion............................................................................................................................28
4 Prior Research.......................................................................................................................31
4.1 Introduction..........................................................................................................................314.2 Initiation of risk disclosure research.....................................................................................314.3 Extent of risk disclosure........................................................................................................32
4.3.1 Surveys..........................................................................................................................324.3.2 Content analysis............................................................................................................344.3.3 Disclosure index............................................................................................................384.3.4 Summarizing table........................................................................................................39
4.4 Factors that influence risk disclosure...................................................................................404.4.1 Studies on financial firms..............................................................................................414.4.2 Studies on nonfinancial firms........................................................................................424.4.3 Other disclosure studies................................................................................................464.4.4 Summarizing table........................................................................................................46
4.5 Usefulness of risk disclosure.................................................................................................484.6 Conclusion............................................................................................................................48
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5 Research Design....................................................................................................................49
5.1 Introduction..........................................................................................................................495.2 Sample selection...................................................................................................................495.3 Content analysis...................................................................................................................505.4 Hypotheses development.....................................................................................................53
5.4.1 Size................................................................................................................................535.4.2 Profitability...................................................................................................................535.4.3 Level of risk...................................................................................................................545.4.4 Multiple listing..............................................................................................................545.4.5 Credit ratings................................................................................................................555.4.6 Organizational structure...............................................................................................555.4.7 Board composition........................................................................................................56
5.5 Regression analysis...............................................................................................................565.6 Independent variable definition...........................................................................................57
6 Analysis and Interpretation of the Results.............................................................................60
6.1 Introduction..........................................................................................................................606.2 Descriptive statistics of the sample......................................................................................606.3 Part I: Risk disclosure practices.............................................................................................60
6.3.1 Risk disclosure score.....................................................................................................606.3.2 Risk categories..............................................................................................................626.3.3 Risk characteristics........................................................................................................646.3.4 Conclusion.....................................................................................................................66
6.4 Part II: Regression analysis...................................................................................................666.4.1 Data analysis................................................................................................................666.4.2 Multiple regression.......................................................................................................676.4.3 Interpretation of the results..........................................................................................696.4.4 Conclusion.....................................................................................................................71
7 Conclusion............................................................................................................................72
7.1 Introduction..........................................................................................................................727.2 Research conclusion.............................................................................................................727.3 Limitations............................................................................................................................737.4 Recommendations for future research.................................................................................74
Reference List................................................................................................................................75
Appendix A...................................................................................................................................80
Appendix B....................................................................................................................................81
Appendix C....................................................................................................................................82
Appendix D...................................................................................................................................83
Appendix E....................................................................................................................................84
Appendix F....................................................................................................................................85
Appendix G...................................................................................................................................86
Appendix H...................................................................................................................................87
Appendix I.....................................................................................................................................88
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1 Introduction
1.1 Prologue
The recent financial crisis is clearly related to risk and risk behavior of individuals and companies as a
whole. The enormous and worldwide consequences the crisis revealed raises questions about the
awareness of risks companies are exposed to, and moreover about the techniques in place to
manage those risks.
In today’s financial system and economic world, banks fulfill an important position, as they allocate
funds from savers to borrowers. Performing this task in an efficient manner lowers the cost of capital
to firms, boosts capital formation and stimulates productivity growth. As a result, the functioning of
banks has ramifications for the operations of firms and the prosperity of nations (Levine, 2004, p. 2).
Since the evolution of financial derivatives, a market with a total value of $ 500 trillion in 2008
(Ormerod, 2008), banks became manufacturers and traders of complex financial products.
The stability of the financial system was heavily affected by the turmoil in financial markets in the
second half of 2007 in the second half of 2007 caused by the sub-prime mortgage loans crisis in the
US (Ryan, 2008, p. 1606). Investments in complex financial products turned out to have much greater
risk than assumed and indicated by credit rating agencies, especially towards the conditions on the
American housing market. As house prices in the US started to fall, banks worldwide were forced to
make major write-downs on the values of these investments. The effects of this turmoil were
transferred also into the operations of the European banks, as distrust between banks and
uncertainty in financial markets started to rise. Banks began to charge additional risk premium for
their interbank loans, resulting in a shortage of credit and illiquid markets.
The essence of any bank is that it is a risk taking enterprise, and therefore, it is expected that
relevant risk-related information will be released to the marketplace to reduce the uncertainty of
investors. Already, banks disseminate significant amounts of information to the marketplace.
However, there have been calls for even greater disclosure of information to ensure users are fully
able to assess the performance of a firm. If shareholders and other interested parties are to be able
to understand the risk profile of the firm, they need to receive information about the risks a firm
faces and how the directors are managing those risks (Linsley and Shrives, 2005a, p. 205).
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Corporate risk reporting is a cornerstone of accounting. For corporations, information on risk can
help to manage change, lower the cost of capital and instruct on the future trajectory of business.
For investors, information on risk can help to determine the risk profile of a company, the estimation
of market value and accuracy of security price forecasts (Abraham and Cox, 2007, p. 227). Risk
reporting has gained interest in financial accounting practice, regulation and research in recent years
(Dobler, 2008, p. 185). Inevitably, this attention will increase due to the current financial crisis. The
crisis shows the urgent need for transparent risk reporting and must be used to learn lessons from,
to prevent current problems to occur again in the near future.
In 2005, Linsley and Shrives (p. 205) already noticed the opinion that at that time limited risk
disclosure occurred by banks. As a result banks were not transparent in this respect. The distrust
between banks, between banks and related parties and between banks and its customers during the
recent credit crunch supports this notion. Improved risk transparency could reduce uncertainty on
the financial markets and therefore tribute to a stable financial environment. Hence, it should
enhance the ability of shareholders and other related parties to manage their risk positions.
1.2 Research question
This thesis focuses on the risk reporting of banks, by first describing their risk disclosure practices,
and second investigating various firm-specific determinants related to the amount of this disclosure.
The following research question will be answered in this research:
In which way do European banks disclose risks in the annual reports of 2007 and which firm-
specific characteristics influence the extent of risk disclosure?
Using risk-related content in the 2007 annual report of 40 randomly selected European Union banks,
this research seeks to explore how risk-related information is communicated to the market by means
of the annual report. The primary objective is to examine the nature and characteristics of risk
disclosures. In addition, this research investigates which firm-specific factors are related to the extent
of this disclosure. In short, this study aims to influence the understanding and thus the practice in
relation to the extent of risk disclosure in the annual reports of the European banking sector and
could therefore be helpful for regulators. They could assess the effectiveness of their regulations and
ensure it has the best chance of achieving the desired outcomes.
The empirical research consists of two steps. First, the risk-related information in the annual reports
is investigated by means of content analysis, a method that has proven to be able to give insight in
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(risk) disclosure practices in the annual report. This information will be categorized into major risk
areas and different attributes (form, qualification and period) will be distinguished. Second, the
gathered data is examined by means of regression analysis, to test for relationships between the
extent of risk disclosure and potential explanatory firm characteristics. These include variables such
as company size, profitability, risk level, multiple listing, credit rating and corporate governance
characteristics.
1.3 Sub questions
For the sake of clarity, the main research question is split up into five sub questions, which will be
discussed in the following chapters:
What is the relevant law and regulation regarding risk disclosures in the annual report?
(chapter 2)
Which economic theories can explain the occurrence and extent of risk disclosure?
(chapter 3)
What are the results of prior risk disclosure research? (chapter 4)
What are the risk disclosure practices of European banks in 2007? (chapter 6)
What firm-specific characteristics are related to the extent of risk disclosures? (chapter 6)
1.4 Relevance
This thesis is embedded in the developing debate as to how the different users of annual reports can
be provided with risk and risk management information that enables them to assess the risk profile
of firms. This debate about risk disclosure started with a Basel Committee paper in 1998, titled
“Enhancing Bank Transparency.” It discussed the significance of disclosure and transparency within
the context of market discipline and banking supervision. The Basel Committee on Banking
Supervision (BCBS, 1998, p. 15) defines bank transparency as “the public disclosure of reliable and
timely information that enables users of that information to make an accurate assessment of a bank’s
financial condition and performance, its business activities and the risks related to those activities”.
Noteworthy, it is argued that banks are generally more opaque than nonfinancial firms (Levine, 2004,
p. 2). For example, Morgan (2002) found evidence that bond analysts disagree more over the bonds
issued by banks than by nonfinancial firms.
Despite the developing debate, Linsley et al. noticed in 2006 (p. 268) that there has been relatively
little research into risk disclosure practices. Discussions concerning how risk reporting can be
developed are often unsupported with empirical evidence. Linsley et al. intend to initiate risk
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disclosure research, and therefore this study responds to this call. Furthermore, the majority of prior
studies on (risk) disclosure have examined annual reports of nonfinancial firms. In addition, the
current financial crisis led to an increased attention towards the banking sector and risk management
in this sector. This further adds up relevance to this subject. Following Linsley et al. (2006) this study
therefore examines risk and risk management disclosure practices within the banking sector.
1.5 Structure
The structure of this thesis is as follows. Chapter 2 elaborates on the institutional framework in which
risk disclosure is embedded. Relevant law and regulation towards risk disclosure will be discussed. In
chapter 3 the theoretical framework is explained, entailing relevant economic theories and
approaches applied to the research subject. In addition, this chapter covers the concepts of risk and
risk management and describes the recent developments regarding risk disclosure. Chapter 4
enumerates prior research on risk disclosures and related aspects. Chapter 5 presents the research
design for the empirical study. In the first part hypotheses will be developed. Furthermore, it explains
the methodology and develops a conceptual model for the regression analyses. The results of the
empirical study will be presented in chapter 6 as well as an interpretation of these results. The thesis
ends with a conclusion, mentions limitations of this study and provides recommendations for future
research in chapter 7.
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2 Institutional Framework
2.1 Introduction
This chapter elaborates on the institutional framework in which risk disclosure is embedded. The
following question will be answered:
What is the relevant law and regulation regarding risk disclosure in the annual report?
First this chapter will discuss the annual report, as a main element in financial reporting. The
subsequent paragraphs will reveal the relevant law and regulation for public listed banks in the
European Union regarding risk disclosures. This regulation subject banks to certain requirements,
restrictions and guidelines: the accounting standards IFRS and the Basel Accords. Furthermore
attention is given to banking supervision in the European Union and the role of central banks and
financial authorities, especially during the credit crisis. Finally, the role of corporate governance
codes is discussed.
2.2 The annual report
Risk disclosures can be found in the annual report, which is a document that is mandated to be
produced every year and expected to provide useful information to users for better decision-making
(Amran et al., 2009, p. 40). The annual report constitutes the main channel of information on the
company’s situation to external users and has been defined as the “main disclosure vehicle” (Beretta
and Bozzolan, 2004). It is an example of the concept of financial reporting, which is the
communication of a wide range of financial and other data to outside interested parties. Information
in the annual report is therefore intended to inform shareholders and other interested parties about
the company’s activities and financial performance.
Shareholders and other related parties have a need for information about the company to make
decisions, for example about buying or selling shares or to provide credit. There is however a conflict
of interests in determining the right information and the right amount of information that should be
communicated. From the company’s perspective as a supplier of information, there is an incentive to
keep information private as much as possible. Shareholders and other outside (related) parties have
the interest to gather as much information as they need to make economic justified decisions.
However, too much information clouds the understanding. Moreover, the demand side is not
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homogeneous, which means that their interest can differ regarding their relationship with the
company (Klaassen and Hoogendoorn, 2004, p. 23-24).
As Klaassen and Hoogendoorn conclude, there needs to be an alignment of supply and demand of
information, which in most western countries with developed capital markets is done by law and
regulation. Deegan and Unerman (2006, p. 32) state that financial accounting tends to be heavily
regulated in these countries, with many accounting standards and other regulations governing how
particular transactions and events are to be recognized, measured and disclosed. The generated
financial statements, such as the balance sheet, income statement, statement of cash flows and
supporting notes are directly impacted by various accounting regulations.
Regulation is in this context the set of rules and standards that govern (financial) institutions. Their
main objective is to foster financial stability and to protect the customers of financial services. It can
take different forms, from information requirements to strict measures such as capital requirements.
Regulation can be distinguished from supervision, which is the process designed to oversee financial
institutions in order to ensure that rules and standards are properly applied (De Larosière, 2009, p.
13). The next paragraphs cover the relevant law and regulation regarding risk disclosures.
2.3 Accounting standards
Accounting standards are authoritative statements of how particular types of transaction and other
events should be reflected in the financial statements. These standards include specific principles,
bases, conventions, rules and practices necessary to prepare the financial statements (Stolowy and
Lebas, 2006, p. 13). The national governments or specific regulatory bodies across the European
Union and the supranational European Commission can be seen as the most important regulators of
the accounting standards. However, in many countries and also in the European Union, accounting
standards are not developed by the government, but created by independent professional bodies.
After a successful standard-setting process, standards are implemented by national governments.
Nowadays, the European Commission implements the accounting standards developed by an
international standard-setting board, the International Accounting Standards Board (IASB).
2.3.1 IFRS
The IASB, based in London, is committed to “develop, in the public interest, a single set of high
quality, global accounting standards that require transparent and comparable information in general
purpose financial statements” (IASB, 2006, p. 3). The set of developed accounting standards is called
International Financial Reporting Standards (IFRSs), applied throughout the European Union as of 1
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January 2005. IFRSs and their interpretations are developed through a formal system of due process
and broad international consultation (IASB, 2006, p. 5-6). IFRS is meant to be an uniform reporting
system, to be applied globally and thereby to enhance the transparency and comparability of
companies throughout the world.
2.3.2 IFRS 7 Financial Instruments: Disclosures
An important standard for banks and related to the research subject of this paper is IFRS 7 Financial
Instruments: Disclosures. This standard incorporates the disclosures relating to financial instruments
required by IAS 32 and replaces IAS 30, a standard about disclosures that was intended only for
banks and similar financial institutions. This means that since the introduction of IFRS 7 all financial
instruments disclosure requirements are located in a single standard for all types of companies (Ernst
& Young, 2007, p. 1). The objective of IFRS 7 is “to require entities to provide disclosures in their
financial statements, that enable users to evaluate (1) the significance of financial instruments for the
entity’s financial position and performance; and (2) 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” (IASB, 2009). Three main risks are mentioned: market risk, credit
risk and liquidity risk (PwC, 2006, p. 4).
The IFRS 7 disclosure requirements require both qualitative narrative descriptions and specific
quantitative data. The level of detail of such disclosures should not overburden users with excessive
detail, but equally should not obscure significant information as a result of excessive aggregation.
Risk disclosures, according to IFRS 7, do not have to be given in the financial statements, but may
either be provided in the financial statements or incorporated into the financial statements by
reference from another statement, for example the management commentary or a separate risk
report. However, as the risk disclosures are required by IFRS, they will be subject to audit (Ernst &
Young, 2007, p. 1).
The requirements to provide quantitative and qualitative market risk disclosures are new and may
represent a significant challenge for many companies (PwC, 2006, p. 2). The IASB defines the
qualitative disclosures as management’s objectives, policies and processes for managing those risks.
The quantitative disclosures has to provide information about the extent to which the entity is
exposed to risk, based on information provided internally to the entity’s key management personnel
(IASB, 2009). As a result, this standard should improve transparency and assist investors in assessing
how companies are managing their risks.
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IFRS 7 applies to all entities, from a manufacturing company whose only financial instruments are
accounts receivable and accounts payable, to a financial institution most of whose assets and
liabilities are financial instruments (IASB, 2009). It is obvious that for banks the IFRS 7 disclosures will
be substantially significant, since they are heavy users of financial instruments.
2.3.3 Regulatory risk reporting
The status of current regulation of risk reporting under IFRSs is predominantly focused on the market
risk associated with the use of financial derivatives, as described in the previous paragraph.
According to Beretta and Bozzolan (2004, p. 267) and Cabedo and Tirado (2004, p. 181), this also
holds for the accounting standards system in the US, the so-called US GAAP (Generally Accepted
Accounting Principles). SFAC No. 133 establishes the compulsory disclosure of market risks arising
from the use of financial assets. Furthermore, Financial Reporting Release No. 48 (FRR 48, 1997)
requires SEC registrants to disclose both qualitative and quantitative information on market risks
arising from adverse changes in interest and foreign exchange rates and in stock and commodity
prices (Cabedo and Tirado, 2004, p. 183). This information needs to be disclosed in the notes to the
accounts and also in the management, discussion and analysis (MDA) section. The same regulatory
principles are applied in Canada. In the UK, the operating and financial review (OFR can be seen as
the equivalent of MDA), was introduced in 1993 for listed companies and is still non-mandatory. In
this review, companies are recommended to disclose its review of key risks and it strongly
encourages the inclusion of a clear discussion of trends affecting the future. In Germany, GAS5
requires information on risks to be presented in a separate section of the management report
(Amran et al., 2009, p. 41).
Although the basic disclosure requirements are comparable, additional regulation per country results
in significant differences in regulation regarding risk reporting. To illustrate this variation appendix A
shows a comparison of risk reporting requirements in the United States of America, according to
IFRSs and in Germany. Most regimes including IFRS and US GAAP follow a piecemeal approach. They
mandate selected risk-related disclosures referring to specific categories of risks and miss therefore a
comprehensive and systematic approach on the reporting of relevant risks (Meijer, 2003, p. 110). An
exception is Germany that has a separate standard (GAS 5) on comprehensive risk reporting. The risk
reporting requirements of US GAAP and IFRSs are however roughly comparable (Dobler, 2008, p.
185).
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2.4 Basel Accords
The Bank for International Settlements (BIS), headed in Switzerland, is an international organization
which fosters international monetary and financial cooperation and serves as a bank for central
banks. One of the key objectives is to promote monetary and financial stability in the banking sector.
For this reason a special committee was appointed in 1974 to enhance understanding of key
supervisory issues and improve the quality of banking supervision worldwide, called the Basel
Committee on Banking Supervision (BIS, 2009).
The Basel Committee does not possess any formal supranational supervisory authority. Rather, the
committee formulates broad supervisory standards and guidelines. It also recommends statements
of best practice in banking supervision in the expectation that the national authorities of their
members will take steps to implement those (BIS, 2009). Their work resulted in the Basel Accords,
which are some of the most influential agreements in modern international finance. Drafted in 1988
and 2004, Basel I and II have ushered in a new era of international banking cooperation. Both accords
have helped harmonize banking supervision, regulation and capital adequacy standards (Balin, 2008,
p. 1). In January 2007 the Basel II Accord was implemented in the European Union via the Capital
Requirements Directive (CRD)2, which is legally binding for every member state of the EU. The CRD
gave financial institutions the option whether to apply the old Basel I rules or the revised Basel II
rules during 2007. However, as of 1 January 2008 institutions have to follow the revised rules of Basel
II (De Nederlandsche Bank, 2007).
The principal purpose of the framework is to create a more stable banking system, based upon three
complementary pillars: (1) capital adequacy requirements, (2) supervisory review and (3) market
discipline. Pillar 1 formulates guidelines for the calculation of a bank’s minimum capital requirements
and pillar 2 sets out the roles and responsibilities of supervisors in reviewing banks’ assessments of
their risks and capital requirements. Pillar 3 is the part of the new accord that has the greatest
significance for this thesis, as it sets out the risk disclosures required to ensure that the market
discipline mechanism can work effectively (Linsley and Shrives, 2005a, p. 207). Appendix B shows a
summary of the disclosure requirements in the 2004 framework, including quantitative and
qualitative disclosures.
The third pillar of Basel II provides a framework whereby banks’ risk exposures will be disclosed to
the marketplace under a common, standardized approach (Linsley and Shrives, 2005a, p. 210). Balin
(2008, p. 12) states, in line with Linsley and Shrives (2005a) that Pillar 3 intends to increase the
2 Consisting of the Directives 2006/48/EC and 2006/49/EC.
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market discipline within a country’s banking sector. The Basel II Accord recommends that disclosures
of a bank’s capital and risk-taking positions, which were once only available to regulators, should be
released to the general public. Furthermore, a full description, including the assumptions, of the risk
mitigation approaches of a bank is recommended for quarterly release to the general public. Balin
(2008, p. 12) point out that Basel II hopes to empower shareholders to enforce discipline in the risk-
taking and reserve-holding methods of banks, where banks seen to hold too few reserves and take
on too much risk are punished by their own shareholders for doing so. This follows the notion of
Linsley and Shrives (2005a, p. 206), who state that, following the importance of transparency,
participants in the marketplace can sanction banks whose financial condition or risk profile is
considered, in some sense, unsatisfactory.
The final version of the Basel II framework was published in July 2006 and, as said before, became
legally binding for every member state of the EU as of January 2007. Basel II was developed to meet
some serious shortcomings in Basel I and greatly expanded the scope, technicality and depth of the
original Basel Accord (Balin, 2008, p. 6). However, Basel II was criticized too. According to the former
general manager of the BIS there are five major criticisms: (1) it is too complex; (2) it reinforces the
procyclicality of the financial system; (3) it gives too much weight to the judgments of rating
agencies; (4) it penalizes small and medium sized enterprises and (5) it does not take adequate
account of the special situation and concerns of emerging countries (Crockett, 2003). Officially there
is no sign of the development of a successor of Basel II. However, already in 2002 Crockett declared:
“The financial world changes all the time and those who supervise and regulate the financial world
have to be prepared to change too. So I do not have any doubt that soon after Basel II is in place, we
will have to start to think about Basel III” (Crockett, 2002). The current financial crisis, which led to an
impressive pressure on the financial system worldwide, even more shows an urgent need to develop
a new or revised framework. At a summit in March 2009, this was recognized by the leaders of the
European Union which led to an agreement that Basel II needs a thorough revision (Visser, 2009).
2.5 Banking supervision
As stated in paragraph 2.2, regulation can be distinguished from supervision. Supervision is the
process designed to oversee financial institutions in order to ensure that rules and standards are
properly applied (De Larosière, 2009, p. 13). This means that banks are monitored by central banks
and financial authorities, because of their important role in today’s economy. In some countries in
the European Union, banking supervision is carried out by the central bank. In other countries this
task is performed by another institution, sometimes in close cooperation with the central bank
(Eijffinger, 2005, p. 459). Together, central banks and financial authorities have the task to supervise
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the payment system, ensure price stability and pursue the stability of banks (Padoa-Schioppa, 1999,
p. 296).
2.5.1 EMU
The European Monetary Union (EMU) is a single market with a common currency, where most (16
out of 27) European Union states are participating in, thereby adopting the euro as their currency.
The remaining countries still use their own currency, including the United Kingdom, Sweden and
Denmark. According to Padoa-Schioppa (1999, p. 296), the institutional framework of banking
supervision in the EMU consist mainly of two parts, national competence and cooperation.
First, national competence. According to the ‘single license’ principle, every bank has the right to do
business in the whole area, under the supervision and regulation of the authority that has issued the
licence. The full supervisory responsibility thus belongs to the home country. Second, cooperation.
The banking industry, a highly regulated single market that retains a plurality of national supervisors,
requires close cooperation among supervisors to safeguard the public good: namely, openness,
competition, safety and soundness of the banking industry (Padoa-Schioppa, 1999, p. 296).
2.5.2 Central Bank and Financial Authorities
Nowadays, most countries in the European Union follow a ‘separation approach’ in banking
supervision, which means that the banking supervision has been assigned to a separate institution
such as a financial authority, instead of the central bank (Padoa-Schioppa, 1999, p. 256). This trend
for central banks to retreat from supervisory functions can be explained as follows. First, banking is
becoming an increasingly complex business and less clearly defined. Second, new developments in
financial supervision increasingly emphasize the role of self-regulation and internal risk management
in financial institutions. Finally, there is increasing acceptance that the government, not the central
bank, should take responsibility for ultimate financial support (Eijffinger, 2005, p. 459).
2.6 Regulation and supervision and the credit crunch
Regulators and supervisors of the banking industry have met considerable critics on their role in the
emergence of the credit crunch. Two main critics can be distinguished, on the requirements of Basel
II and on the role of supervisors.
First, Basel II is a procyclical system. This means that banks facing defaults on credit payments need
more capital, which they can hardly attract because of their worsening liquidity position. Another
problem with Basel II is that banks are allowed to use their own internal risk models to value their
14
investments. This means that companies are encouraged to make lower risk estimates. In the
preceding years of economic growth, before the current credit crunch, this has led to a decline in the
capital hold by banks, making them more vulnerable to deteriorating economic circumstances. A
third problem is the scope of the Basel II Accords: banks moved their riskiest investments away from
the balance sheet and put them into special purpose vehicles (SPVs), thereby circumventing the
requirements (Visser, 2009).
Second, the supervision of the banking industry lies primarily at the national central bank and/or
local financial authorities. This approach has among certain advantages one major disadvantage
related to systemic risk. It was too much focused on the micro-prudential supervision of individual
financial institutions and not sufficiently on the macro-systemic risks of a contagion of correlated
horizontal shocks. Furthermore, strong international competition among financial centers
contributed to national regulators and supervisors being reluctant to take unilateral action, known as
‘regulatory competition’ (De Laroisère, 2009, p. 11).
However, not all supervisors were inadequate in their supervision. One example can be found in
Spain. The supervision, carried out by the Spanish central bank (Banco de España), is more
conservative and has more stringent requirements than Basel II. The additional requirements have a
countercyclical character, which means that in good times banks are forced to make more provisions,
to use them in bad times. Before the credit crunch, Spanish banks had therefore a much stronger
capital position than other European Banks (Visser, 2009). Furthermore, the central bank demanded
that banks post an 8 per cent capital charge against assets put in SPVs. That essentially killed this
lucrative business by removing incentives to create these creatures (Tett, 2008).
2.7 Corporate governance codes
A recent development in the worldwide corporate business world is the application of corporate
governance codes for public companies throughout many western countries. This development was
a response to some high-profile accounting fraud scandals, involving well-respected companies as
energy giant Enron (2001) and internet company WorldCom (2002) in the US. In Europe, accounting
fraud was discovered at dairy giant Parmalat (2003) in Italy and international food retailer Ahold
(2003) in the Netherlands (Mecking, 2008). In the wake of these corporate scandals there has been
an increased demand for more disclosures (Amran et al., 2009, p. 39).
Especially regarding these scandals, the integrity of financial reporting is a consistent concern among
regulators and practitioners (Chen et al., 2007, p. 3). As a consequence of these improper practices
15
attention has been focused on the need for strong corporate governance mechanisms within
companies (Davidson et al., 2005). Since 1992, reports, best practices, guidance and codes about
corporate governance for public listed companies were published and implemented in at least 67
countries worldwide (European Corporate Governance Institute, 2009). Cabedo and Tirado (2004, p.
183) pointed out that these documents, among other issues, emphasize on the need to disclose the
risks a firm faces, as part of their internal control systems.
Corporate governance is defined as the set of mechanisms (both institutional and market-based) that
induce the self-interested managers of a company to make decisions that maximize the value to its
owners, the suppliers of capital (Denis and McConnell, 2003, p. 2). The concepts of corporate
governance heavily rely on the necessity of internal controls. Internal controls help ensure that
processes operate as designed and that risk responses in risk management are carried out. The
guidance on the Turnbull Report (the UK corporate governance code) states: “A company’s system of
internal control has a key role in the management of risks that are significant to the fulfilment of its
business objectives” (Financial Reporting Council, 2005, p. 3). Transparency will be enhanced by
improving the disclosure of internal control. That should ultimately lead to improvements in the
communication links between investors and their investee companies (Solomon et al., 2000).
A wide variety of organizations in the EU Member States have issued corporate governance codes,
including governmental or quasi-governmental entities, committees or commissions organized or
appointed by governments, stock-exchange-related bodies and business, industry and academic
associations. Given the variety of the groups involved in developing codes, compliance mechanisms
and the “official” status of codes varies widely. However, all of the codes call for voluntary adoption
of their substantive recommendations. Some codes advocate or mandate (through linkage to stock
exchange listing requirements) disclosure by listed companies of the degree to which they comply
with code recommendations, together with an explanation of any areas of non-compliance. Such
disclosure against a code is referred to as disclosure on a “comply or explain” basis (Weil, Gotshal &
Manges LLP, 2002, p. 2, 16). Despite the divergence of corporate governance practices amongst EU
Member States, the European Commission reached the conclusion that a uniform corporate
governance code should not be adopted. Alternatively, the European Commission decided to
harmonize the codes’ enforcement mechanisms through Directive 2006/46/EC, which introduced the
comply-or-explain principle for the first time in European law. Although the concept of comply-or-
explain had already been in place in many EU Member States, the Directive makes the use of this
concept mandatory (RiskMetrics Group, 2009, p. 11, 27).
16
Also the Basel Committee on Banking Supervision (BCBS) focused attention towards corporate
governance and emphasized the urgency of good corporate governance in banks. The bank published
a paper in 1999 named: ‘Enhancing corporate governance for banking organizations’ (revised in
2006). This paper was issued to supervisory authorities and banking organizations worldwide to help
ensure the adoption and implementation of sound corporate governance practices by banking
organizations. One of the statements is that effective banking supervision is difficult if sound
corporate governance is not in place (BCBS, 1999, I.3). Hence, banking supervisors have a strong
interest in ensuring that there is effective corporate governance at every banking organization. The
crucial importance of strong corporate governance is underscored by the fact that banking is virtually
universally a regulated industry and that banks have access to government safety nets (BCBS, 1999,
II.7). The relation between corporate governance, transparency and risk disclosures will be discussed
further in paragraph 3.3 and beyond.
Another important notion in the BCBS 1999 paper is that there are no universally correct answers to
structural issues and that laws need not to be consistent from country to country, due to various
corporate governance structures in different countries. The paper therefore states that sound
governance can be practiced regardless of the form used by a banking organization (BCBS, 1999).
Regarding to this research, it is therefore complex to investigate relationships between risk
disclosures and corporate governance variables.
2.8 Conclusion
This chapter investigated the institutional framework of risk disclosures, in the context of relevant
law and regulation. For public listed banks in the European Union this includes the accounting
standards IFRS, in particular IFRS 7 (Disclosures of Financial Instruments), and the Basel Accords,
containing recommendations on banking laws, regulation and supervision. Furthermore, additional
regulation can vary per individual country. In addition, there has been increased attention towards
corporate governance in organizations including banks. One conclusion is that the regulation mainly
has been harmonized throughout the European Union. The execution of banking supervision is
however primarily national oriented, by the national central bank and/or financial authority. Using
the information in this chapter, a figure has been drawn which summarizes the situation of a public
listed bank in the European Union (see figure 1).
The recent credit crunch revealed two major weaknesses of this system. First, the regulation was
blamed to be too procyclical and second, the supervision was not sufficiently focused on macro-
systemic risks. Not surprisingly, the crisis evoked a discussion about the current status of the whole
17
banking regulation and supervision system, and therefore a reform (in the direction of stricter
regulation and more supervision) can be definitely expected.
Figure 1 The institutional framework of a public listed bank in the European Union
18
3 Theoretical Framework
3.1 Introduction
This chapter discusses the theoretical framework regarding risk disclosures in the annual report. The
following question will be discussed:
Which economic theories can explain the occurrence and extent of risk disclosure?
The Positive Accounting Theory is discussed in the second paragraph. Another applicable economic
theory is the agency theory, which is discussed in the third paragraph. The emphasis lies upon the
information asymmetry between the agent and the principle. Information that is disclosed in the
annual report is a major tool to overcome this information asymmetry. The role of disclosure and risk
disclosure in specific is therefore discussed in the fourth paragraph. Information plays an essential
role in financial markets and for that reason the efficient market hypothesis is discussed in the fifth
paragraph. The sixth paragraph starts with describing the concept of risk and the process of risk
management. The next paragraph explains the most common banking risks. In the eighth paragraph
a brief development of risk disclosure is given and attention is drawn to some issues arising out of
the risk disclosure debate. The chapter ends with a conclusion.
3.2 Positive Accounting Theory
The preparation of the financial statements is generally the responsibility of the (board of) directors
(Abraham and Cox, 2007, p. 231). Within the overall process of corporate governance, they make
accounting policy choices and determine to which extent information such as risk disclosure is
disclosed or not. The Positive Accounting Theory (PAT), popularized by Watts and Zimmerman,
studies managers’ accounting policy choices and is therefore important for this research.
According to Scott (2006, p. 240), PAT is “concerned with predicting such actions as the choices of
accounting policies by firm managers (…)”. Viewing a firm as a nexus of contracts, PAT asserts that
accounting policy choice is part of the firm’s overall need to minimize its cost of capital and other
contracting costs (Scott, 2006, p. 252). Many of these contracts involve accounting variables. Giving
management flexibility to choose from a set of accounting policies opens up the possibility of
opportunistic behavior. This means that managers may choose accounting policies from the set for
their own purposes, thereby reducing contract efficiency. The reason for that is the assumption that
managers are rational (like investors) and are therefore expected to choose accounting policies in
19
their own best interests if able to do so (Scott, 2006, p. 240-243). As a solution, PAT predicts that
contractual arrangements will be put in place to align the interests of the various self-interested
parties (Deegan and Unerman, 2006, p. 252).
The predictions made by PAT are largely organized around three hypotheses. First, the bonus plan
hypothesis predicts that managers of firms with bonus plans are more likely to choose accounting
procedures that shift reported earnings from future periods to the current period. Second, the debt
covenant hypothesis predicts that the closer a firm is to violation of accounting-based debt
covenants, the more likely the firm manager is to select accounting procedures that shift reported
earnings from future periods to the current period. Third, the political cost hypothesis predicts that
the greater the political costs faced by a firm, the more likely the manager is to choose accounting
procedures that defer reported earnings from current to future periods. This hypothesis introduces a
political dimension into accounting policy choice. Political costs can be imposed by high profitability,
which may attract media and consumer attention. Such attention can quickly translate into political
pressure on the firm as politicians may respond with taxes or other regulation (Scott, 2006, p. 243-
244).
The political cost hypothesis has been suggested to explain why firms make social disclosures.
Numerous empirical studies have directly sought to establish evidence for the political cost
hypothesis as an explanation for firms’ social disclosures (Milne, 2001, p. 1). Milne explains that,
according to Watts and Zimmerman’s theory, the answer why managers make social disclosures is
because it is in their interests to do so. In my opinion, this reasoning can also be applied to
(voluntary) risk disclosures. Large profits could for example be explained by disclosing information
about superior risk management.
3.3 Agency theory
To study the process of contracting (as emphasized by the PAT) the agency theory is very useful. The
agency theory models the process of contracting between two or more persons (Scott, 2006, p. 259).
The theory was first developed by Jensen and Meckling (1976) and proposes that within the joint
stock company the interests of managers diverge from those of the owners. The principals (owners)
will assume that the agents (managers) will be driven by self-interest. Therefore the principals will
anticipate that the agents will undertake self-serving activities that could be detrimental to the
economic welfare of the principals (Deegan and Unerman, 2006, p. 213-214). In this research, the
principals can be defined as the shareholders and/or users of the financial statements and the agents
are the managers of the banks.
20
According to Prat (2005, p. 862), there is a widespread consensus that principal-agent relationships
should be transparent as possible. If agency relationships are not transparent, some parties have an
information advantage over others, which is called information asymmetry. This is caused by the
position of the agents within the firm where they will have access to information not available to the
principals (Deegan and Unerman, 2006, p. 224). This information asymmetry between the agent and
the principal can be effectively mitigated if the firm is able to provide better levels of transparency
and disclosure (Chen et al., 2007, p. 658). In this theoretical framework, transparency is defined as
“the ability of the principal to observe how the agent behaves and the consequences of the agent’s
behavior” (Prat, 2005, p. 862). Prat argues that transparency improves accountability, which in turn
aligns the interests of the agent with the interests of the principal.
Related to the banking sector, Linsley and Shrives (2005a, p. 206) argue that the importance of
transparency is that if relevant information is released into the public domain, then participants in
the marketplace can sanction banks whose financial condition or risk profile is considered
unsatisfactory. On the contrary, banks whose financial condition or risk profile indicates that they are
well managed can benefit from disclosing appropriate information since the market’s disciplining
mechanism can offer incentives as well as sanctions.
3.4 Stakeholder theory
Another positive theory3 is the stakeholder theory. This theory provides alternative explanations
(alternative to PAT) about what drives an organization to make particular disclosures (Deegan and
Unerman (2006, p. 258). Furthermore, this theory is strong in explaining the interrelatedness of a
company and its stakeholders and has been used in multiple other disclosure studies (Amran et al.
(2009, p. 44). Developed by Freeman, a stakeholder is defined as “(…) any group or individual who
can affect or is affected by the achievements of an organisation’s objectives” (Freeman, 1984, p. 46).
Essentially, stakeholder theory is about the dynamic and complex relationship between the
organization and its surroundings (Amran et al., 2009, p. 44). The organization is considered to be
part of a wider social system. Moreover, it is assumed that the expectations of the various
stakeholder groups will impact on the operating and disclosure policies of the organization. The
organization will not respond to all stakeholders equally, but rather, will respond to those that are
deemed to be powerful (Deegan and Unerman, 2006, p. 289). As a result, the organization will tend
to satisfy the information demands of those stakeholders who are important to the organization’s
ongoing survival. The disclosure of information is considered to represent an important strategy in
3 A positive theory is a theory that seeks to explain and predict particular phenomena (Deegan and Unerman, 2006, p. 206)
21
managing stakeholders (Deegan and Unerman, 2006, 299). For example, Linsley and Shrives (2005b,
p. 302) point out that the positive relationship between company size and number of disclosures is
thought to be hold because larger companies have greater numbers of stakeholders to whom they
are accountable and as a consequence, they must provide more information.4
3.5 The role of disclosure
Corporate disclosure is critical for the functioning of an efficient capital market. Firms are providing
disclosure through regulated financial reports, including financial statements, footnotes and other
regulatory filings. The demand for financial reporting and disclosure arises from information
asymmetry and agency conflicts between managers and outside shareholders. The disclosure of
relevant information enables shareholders to evaluate the performance of the managers (Healy and
Palepu, 2001, p. 406, 412). This view is shared by the Basel Committee on Banking Supervision:
“Transparency of information related to existing conditions, decisions and actions is integrally related
to accountability in that it gives market participants sufficient information with which to judge the
management of a bank” (BCBS, 1999). In addition to mandatory disclosures, firms engage more or
less in voluntary communication. According to Dia and Zeghal (2008, p. 237), voluntary information
disclosure by management targets the lack of informational symmetry between managers and
shareholders.
Regarding the market’s disciplining mechanism as described in paragraph 3.3, it is argued that banks
that disclose greater amounts of useful risk information should benefit from a reduction in their cost
of capital. After all, the providers of funds will be better positioned to judge the bank’s risk level and
this will remove the need for them to incorporate a risk premium within the cost of capital. On the
other hand, banks that are reluctant to disclose risk information may not experience more expensive
funding but also that these are more difficult to access (Linsley and Shrives, 2005a, p. 206). Engels
(2008) confirms this view and states that higher disclosure quality and stricter disclosure
requirements (regarding the introduction of IFRS 7) could lead to less information asymmetry and
previous literature suggest that this will ultimately lead to a lower cost of capital.
Linsley and Shrives (2005a, p. 206) mention another aspect of risk disclosure. They argue that
increased risk disclosure can help bank supervisors to be more effective in their monitoring as they
are better positioned to foresee potential problems and therefore can act earlier. Furthermore, risk
disclosure has disciplining effects. If banks recognize that they need to disclose risk information, then
an incentive exists for them to improve their risk management capabilities as they will not want to be
4 See also Amran et al. (2009, p. 51).
22
viewed as inferior to other banks in this respect. This rise in risk management abilities across the
banking sector will, in turn, create more stability within the industry, hence reducing systemic risk.
Chen et al. (2007, p. 644) argue that financial transparency and information disclosure are crucial
elements of good corporate governance. Within firms that adopt poor financial transparency and
information disclosure practices, managers are more likely to use their information advantage to
pursue a private benefit of control. Ultimately this will lead to an increase in the agency cost, faced
by shareholders. According to Chen et al. (2007, p. 644), disclosure practices can be viewed as
effective mechanisms for the protection of the rights of outsiders. Therefore, an improved level of
transparency and disclosure practices ultimately leads to better corporate governance (Linsley and
Shrives, 2005, p. 303). Hence, good corporate governance is acknowledged to be a solution to the
agency problem (O’Sullivan, 2000). After all, better transparency and disclosure practices can help
shareholders to gain a better understanding of firms’ management practices and thereby help to
reduce the information asymmetry faced by shareholders.5
It is obvious to conclude that higher amounts of disclosures, whether or not combined with a higher
quality, lead to higher levels of transparency. However, Linsley and Shrives (2005a, p. 206) point out
that only disclosure of ‘useful’ information will create transparency. The Basel Committee (BCBS,
1998, p. 15) states that the fundamentally important qualitative characteristics that will contribute to
transparency are: timeliness, comprehensiveness, reliability, relevance, comparability and
materiality. Furthermore, Morgan (2002) states that high quality disclosures by banks may not
necessarily result in reduced levels of information asymmetry if these banks are not transparent in
the first place. However, Brown and Hillegeist (2007) found evidence that there is a negative
relationship between disclosure quality and information asymmetry.
3.6 Efficient market hypothesis
As said in the previous paragraph, disclosure is critical for the functioning of an efficient capital
market. According to Scott (2006, p. 88), efficiency implies that the information content of disclosure
is valued by the market. Theory about efficient securities market indicates what the primary reason
for the existence of accounting is, namely information asymmetry (see also paragraph 2.2). Market
efficiency does not guarantee that security prices fully reflect real firm value. It does suggest,
however, that prices are unbiased relative to publicly available information and will react quickly to
new or revised information. Deegan and Unerman (2006, p. 210) acknowledge the development of
5 This is also argued by Solomon et al. (2000, p. 450) and Dobler (2008, p. 187).
23
the Efficient Markets Hypothesis (EMH) crucial to the development of the Positive Accounting
Theory.
The EMH is based on the assumption that capital markets react in an efficient and unbiased manner
to publicly available information. The perspective taken is that security prices reflect the information
content of publicly available information, which is not restricted to accounting disclosures (Deegan
and Unerman (2006, p. 210). There are three forms of EMH and each is becoming successively
stronger in implication. As market prices correctly represent all the information contained in the
record of past prices and trading volume, then the weak form of EMH can be applied. If market prices
also rapidly adapt to new information and present public information currently widely known, the
semi-strong form of EMH can be applied. The strong form of EMH can be applied if, besides the
previous two, the market prices also accurately represent predicted future information, which
includes private information (Douglas, 2007, p. 1-2).
Scott (2006, p. 239) suggest the existence of an anomaly regarding the EMH. The efficient securities
market theory predicts no price reaction to accounting policy changes that do not impact underlying
profitability and cash flows. Consequently, if there is no share price reaction, it is unclear why
management and regulators should be particularly concerned about the accounting policies that
firms use. Efficient markets theory implies the importance of full disclosure, including disclosure of
accounting policies. However, once full disclosure of accounting policies is made, the market will
interpret the value of the shares in the light of the policies used and will not be fooled by variations
in accounting numbers that arise solely from differences in accounting policies.
3.7 Risk and risk management
Risk is an inescapable element of any business venture. The concept of risk relates to a distribution of
future outcomes. In a business context, risk can be driven by various external and internal factors or
sources. Risk factors comprise, for example, politics, regulation, market, finance, business process
and personnel. All of them potentially affect an entity’s future performance (Dobler, 2008, p. 187).
Since risk is mostly associated with losses, Amran et al (2009, p. 40) defines risks as conditions that
can adversely affect the conditions of a company and moreover the price of its securities. Hence, it is
in the interest of the shareholder that risk related information is disclosed in a timely manner.
Financial institutions operate within increasingly unpredictable and unstable external environments,
while at the same time being at the forefront of advances in risk management techniques, according
to Linsley and Shrives (2005a, p. 205). Amran et al. (2009, p. 40) acknowledge the increasing
24
complexity of doing business, which has evoked a situation in which risk management has become an
important and integral part of the company’s internal control and governance in order to achieve its
plans and objectives. Amran et al. (2009, p. 40) define risk management as “the methods and
processes used by organizations to manage risks (or seize opportunities) related to the achievement
of their objectives”. Risk management is, according to Solomon et al. (2000, p. 448), essential for the
maximization of shareholders’ wealth as it aims to maximize profitability while at the same time
reducing the probability of financial failure.
Risk management and internal control evidently overlap. The objectives of a company, its internal
organization and the environment in which it operates are continually evolving and, as a result, the
risks it faces are continually changing. A sound system of internal control therefore depends on a
thorough and regular evaluation of the nature and extent of the risks to which the company is
exposed. Indeed, profits are more or less the reward for successful risk-taking in business and the
purpose of internal control is to help manage and control risk appropriately rather than to eliminate
it (Financial Reporting Council, 2005, p. 3).
Lajili and Zeghal (2005) describe a typical risk management framework involving a few processes.
Firstly, there is the identification, measurement and assessment of risk types that a company might
face. Secondly, a response model has to be formulated to tackle risks. The risk bearing capacity, risk
reduction or mitigation procedures need also to be determined. Finally, the implementation of all the
actions planned as proposed by the response model needs to be monitored and checked. Amran et
al. (2009, p. 41) argue that by identifying and proactively addressing risks and opportunities, the
company protects and creates value for their stakeholders. Such risk management has been
mandated to be disclosed by the accounting standard boards in some developed countries. However,
risk management disclosure is still very much voluntary in many parts of the world.
In current risk management practices Value-at-Risk (VaR) is a major tool. VaR refers to the maximum
likely loss from an exposure for a given time horizon and solvency standard and result in information
that can be easily disclosed. However, a main problem with this tool is its scope: the tool applies only
to a small proportion of financial risk: market risk in trading activities. The assumption of a neutral
attitude towards risk, such that large losses with low probability are not penalized in capital
requirements more than small losses with larger probability of occurrence is problematic as
operational risks are underestimated (Sundmacher, 2006, p. 3).
3.8 Banks and their (specific) risks
25
Banks are in the risk business. In the process of providing financial services, they assume various
kinds of financial risks (Santomero, 1997, p. 2). The risks associated with the provision of banking
services differ by the type of service rendered. For the sector as a whole, risks can be classified into a
number of generic types. Based upon the classifications of Santomero (1997, p. 8-10) and Pyle (1997,
p. 3) the following major risks areas can be distinguished: (1) market risk; (2) credit risk; (3) liquidity
risk; (4) operational risk and (5) legal risk. All financial institutions face all these risks to some extent.
The next paragraph will explain these risks, as major sources of value loss, related to banking
activities.
Pyle (1997, p. 3) defines risk in the same way as Amran et al. (see previous paragraph). Risk in the
banking context can be defined as reductions in firm value due to changes in the business
environment. Market risk (1) is the change in net asset value due to changes in underlying economic
factors such as interest rates, exchange rates and equity and commodity prices (Pyle, 1997, p. 3).
Santomero (1997, p. 8) classifies market risk somewhat different under systematic risk. All investors
assume this type of risk, whenever assets owned or claims issued can change in value as a result of
broad economic factors. For the banking sector, Santomero mentions two factors of greatest
concern, namely variations in the general level of interest rates and the relative value of currencies.
Banks try to estimate the impact of these particular systematic risks on performance, attempt to
hedge against them and thus limit the sensitivity to variations in these factors (Santomero, 1997, p.
8).
Credit risk (2) is the change in net asset value due to changes in the perceived ability of
counterparties to meet their contractual obligations (Pyle, 1997, p. 3). It arises from non-
performance by a borrower and may arise from either an inability or an unwillingness to perform in
the pre-committed contract manner. The real risk from credit is the deviation of portfolio
performance from its expected value. As such, credit risk is diversifiable, but difficult to eliminate
completely. In fact, a portion of the default risk may result from the systematic risk outlined above.
Counterparty risk can be seen as a form of credit risk, as it comes from non-performance of a trading
partner. However, Santomero points out that counterparty risk is generally viewed as a more
transient financial risk associated with trading than standard creditor default risk (Santomero, 1997,
p. 9).
Leenaars (2003, p. 341) asserts that liquidity risk (3) has three perspectives: the inability of the bank
to (re)finance against normal costs, the liquidity risk of the market and the liquidity risk of the type of
assets. Santomero (1997, p. 10) describes liquidity risk as the risk of a funding crisis. Such a situation
would inevitably be associated with an unexpected event, such as a large charge off, loss of
26
confidence or a crisis of national proportion. The recent credit crunch is an example of a funding
crisis. Risk management activities need to focus on liquidity facilities and portfolio structure.
Operational risk (4) arises from costs incurred through mistakes made in processing, settling, and
taking or making delivery on trades in exchange for cash. It also arises in record keeping, processing
system failures and compliance with various regulations (Santomero, 1997, p. 10). Operational risk is
clearly a multitude of different risks that, if preferred, separately can be appointed (Leenaars, 2003,
p. 346).
Legal risks (5) are endemic in financial contracting and are separate from legal ramifications of credit,
counterparty and operational risks. New statutes, tax legislation and regulations can put formerly
well-established transaction into contention even when al parties have previously performed
adequately and are fully able to perform in the future. A second type of legal risk arises from inside
the company. Fraud, violation of regulations or laws and other actions by management or employees
can lead to catastrophic loss (Santomero, 1997, p. 10).
3.9 Risk disclosure: development and discussion
Though acknowledging the increase in risk management practices within financial institutions, Linsley
and Shrives (2005a, p. 206) argue that the increase in awareness of risk and risk management did not
(yet) led to an increase in the release of risk-related information. Furthermore, current annual
reports do provide some form of risk disclosure, but not in a comprehensible manner for the
stakeholders to understand (Linsley and Shrives, 2006). In addition, Engels (2008) states that
research on the quality of disclosures of the banking sector suggest that these disclosures, especially
risk disclosures are indistinct. This is also noticed at firms in common: the risk information as it
currently stands is too brief, not sufficiently forward looking and not wholly adequate for decision-
making purposes (Beretta and Bozzolan, 2004; Cabedo and Tirado, 2004, p. 183).
Research around the millennium change carried out by the Basel Committee on Banking Supervision
(2001, 2002, and 2003) observed a general trend that banks are disclosing more information.
However, according to Linsley and Shrives (2005a, p. 210) there is still a need for greater disclosure if
Pillar 3 compliance is to be achieved. A recent paper of KPMG (2008) investigates financial risk
disclosure of financial institutions among the European Union and emphasizes on the importance of
transparency. Companies operating in financial services are often exposed to complex risks that are
very hard for an investor to evaluate. Lack of transparency is therefore widely seen as a major reason
27
for valuation gaps between financial sector companies and other companies. The paper concludes
that risk disclosure can be improved significantly with limited effort. The overall level of disclosure at
most institutions is suffering due to “black holes”. In other words, a comprehensive approach on
disclosing risks is missing. Relevant pieces of risk information are missing in annual reports, according
to KPMG (2008, p. 5). The Basel II Accord has however led to an increase in the level of risk and
capital management related disclosure. The implementation of Basel II via the Capital Requirements
Directive (CRD) has resulted in some banks publishing a separate Pillar 3 document in connection
with the annual report (KPMG, 2008, p. 9). The next chapter will discuss the results of these studies
in more detail.
Opposed to the call for more risk-related information, some pose critical notes. The first issue is that
managers can be reluctant to provide detailed risk and risk management information if they consider
it to be commercially sensitive and therefore of potential value to competitors. Linsley et al. (2006, p.
269) mention this problem as the problem of proprietary information. The second issue concerns the
disclosure of forward-looking risk information. A paper of the Institute of Chartered Accountants in
England and Wales (ICAEW, 1998) states that companies should be providing forward-looking risk
information and not only historical information. Forward-looking information is much more useful for
decision-making. It is however understandable that managers can be reluctant to publish information
of this type, as it is inherently unreliable and could leave managers open to potential claims from
investors who have acted upon this information. Linsley and Shrives (2005a, p. 210) elaborates
further on this issue and point out that there is a tension between relevance and reliability. Forward-
looking risk information is potentially of great relevance, but also inherently unreliable.
3.10 Conclusion
This chapter discusses the theoretical framework and has focused on economic theories that can
explain the occurrence and extent of risk disclosure. The PAT studies managers’ accounting policy
choices and is therefore relevant to this research. The political cost hypothesis is suggested to explain
why firms make (voluntary) risk disclosures. Agency theory is useful in study the process of
contracting. Principal-agent relationships should be transparent as possible, but this transparency is
set back by information asymmetry between the agent and the principal. Providing better levels of
transparency and disclosure is proposed to be able to effectively mitigate information asymmetry
and improve corporate governance. Stakeholder theory provides alternative explanations about
what drives an organization to make particular disclosure. Large companies (which listed banks often
are) must provide more information because they have greater number of stakeholders to whom
they are accountable. Figure 2 outlines the situation as illustrated in this chapter.
28
Figure 2 The risk disclosure framework
Applying these theories to the banking sector, it can be concluded that increased transparency would
strengthen market discipline. Participants in the market place can sanction banks whose risk profile
are considered unsatisfactory but can also reward banks with appropriate risk management.
Furthermore, better levels of risk disclosure should banks enable to benefit from a reduction in their
cost of capital, paying lower risk premiums, as the providers of funds (often other banks) will be
better positioned to judge the bank’s risk level. In recent developments, it can be seen that this
analysis is followed by regulators, since market discipline is a key element in modern regulatory
frameworks in the banking sector. Figure 3 shows the effects of improved (quantity and/or quality of)
risk disclosure as discussed in this chapter.
Figure 3 The effects of improved risk disclosure
The last parts of this chapter covered risk(s), risk management and its development in the banking
sector. Risk management practices have increased and become even more an integral part of the
banks’ business. Surveys in the financial sector show an increase in the release of risk-related
information, but it is still too brief, not sufficiently forward looking and not presented in a
comprehensible manner for the stakeholders to understand. There have been calls for greater and
29
more relevant risk disclosure, but others pose critical notes towards these calls regarding the
problem of proprietary information and the chance of litigation.
30
4 Prior Research
4.1 Introduction
There has been extensive research in the developed countries to examine the corporate disclosure in
financial and non-financial companies. The focus of this chapter lies upon prior research on risk
disclosure in (financial) companies. The following question will be answered in this chapter:
What are the results of prior risk disclosure research?
The second paragraph introduces the research papers that have evoked the research on risk
disclosure by financial institutions. In the third paragraph studies on the extent of risk disclosures are
discussed, on both financial and non-financial companies. The fourth paragraph continues with
studies on the factors that influence risk disclosures. Research on the usefulness of risk disclosure is
discussed in the fifth paragraph. Studies examining the association between the volume of risk
disclosures made by banks within their annual reports and potentially relevant variables are very
scarce, and that is the reason that also studies examining risk disclosure in nonfinancial firms are
reviewed. The literature review in this chapter is used to develop hypotheses in the next chapter.
4.2 Initiation of risk disclosure research
A large number of disclosure studies have been performed in the last 30 years but their primary
focus has been analyses of corporate disclosures in general. Additionally, the majority of these prior
studies have examined the annual reports of non-financial firms. The study of Linsley et al. (2006)
specifically focused on risk and risk management disclosure within the banking sector and had
therefore an exploratory aspect. With their paper, they intend to initiate risk disclosure research in
the financial services arena (Linsley et al., 2006, p. 268). The results of their study will be discussed in
paragraph 4.3.2.
Before academic (empirical) research on the risk disclosure started, two papers were published in the
field of accountancy focusing on risk and risk reporting. In 1998, it was the Institute of Chartered
Accountants in England and Wales (ICAEW) that started a debate on the importance of risk reporting,
publishing a discussion paper entitled “Financial Reporting of Risk”. The paper stated that quoted UK
companies should voluntarily undertake to disclose risk information within a separate statement
contained within the annual report. Furthermore, it concluded that the annual report did not present
31
a coherent discussion of the risks that challenge the company and the action the directors are
undertaking to manage those risks (Linsley and Shrives, 2005a, p. 211-212).
The second paper (Schrand and Elliot, 1998) summarizes presentations and debates on an AAA/FASB
(American Accounting Association / Financial Accounting Standards Board) conference about “Risk
and Financial Reporting”. They noted fundamental inadequacies in regulatory requirements
regarding risk disclosures and concluded that companies have no incentives for voluntary disclosures
about risk. Concurrent to the previous papers, the Basel Committee on Banking Supervision (BCBS,
1998) issued a paper ‘Enhancing Bank Transparency’ related to the disclosure of risk information in
the banking sector. Already mentioned in the first chapter, this paper discusses the critical
importance of disclosure and transparency within the context of banking supervision. It
recommended banks to disclose six categories of information within their annual reports. Two of
these information categories are risk exposures, and risk management strategies and practices
(Linsley et al., 2006, p. 269-270).
4.3 Extent of risk disclosure
This paragraph discusses prior research on the extent of risk disclosures. First, the results of a few
surveys are shown. Second, studies using content analysis are reviewed. After that, studies using
other methods than content analysis are discussed. The paragraph ends with a summarizing table.
4.3.1 Surveys
The Basel Committee on Banking Supervision (BCBS) has published three studies to date (2001, 2002
and 2003) examining bank disclosures in general. The studies adopted identical research methods,
although the number of sampled banks differed slightly between the three years. The survey
instrument comprised a detailed list of 104 questions that the Basel Committee considered useful for
their own disclosure review purposes. These questions are grouped into 12 categories. The intention
of these surveys was to give an impression of the current disclosure practices for comparison with
the disclosure proposals of the Committee. Generally, there has been an increase in disclosure noted
by the bank supervisory authorities. A summary of the results of the three surveys are shown in table
1 (Linsley et al., 2006, p. 271).
32
Table 1 Summary of the surveys of the Basel Committee on Banking Supervision
Disclosure categories Number of questions per category
Percentage of ‘yes’ responses compared with ‘no’ responses
1999 (%) 2000 (%) 2001 (%)1. Capital structure 14 73 78 822. Capital adequacy 7 46 48 553. Market risk and internal modeling 16 64 66 684. Internal and external ratings 4 32 35 465. Credit risk modeling 5 32 33 336. Securitization activities 8 29 36 457. Credit risk 13 55 56 618. Credit derivatives, other credit enhancements
6 24 25 34
9. Derivatives 9 58 56 6210. Geographic and business line diversification 10 65 63 6511. Accounting and presentation policies 7 82 84 8412. Other risks 5 62 74 84Total 104
Although the BCBS studies above examined bank disclosures in general, their conclusion can also be
applied to risk disclosures. The 2003 paper states: “Banks continued to improve significantly the
disclosure on information on liquidity, operational and legal risks as well as interest rate risk in the
banking book. This information has now become as commonly disclosed as the basic information on
market risk or credit risk” (BCBS, 2003, p. 23). The rate of banks disclosing “other risks” (operational
and legal risks, liquidity risk and interest rate risk in the banking book) increased from 65% in 1999 to
84% in 2001. Linsley and Shrives (2005, p. 210) partly attribute this to the considerable increase in
awareness of operational risk matters that has occurred during that time. Although showing an
increase, less widespread were disclosures on credit risk modeling, credit derivatives and other credit
enhancements (from 24% in 1999 to 34% in 2001). Disclosure of information on internal risk models
was also much more common for market risk than for credit risk (68% versus 33% in 2001).
A recent paper of KPMG (2008) shows the result of a survey among financial institutions in Europe
about financial risk disclosure. In the banking area, KPMG (2008, p. 6) assesses six areas of risk
disclosure, namely credit risk (1), market risk (2), ALM (asset and liability management) and treasury
risk (3), operational risk (4), business risk (5) and overall risk related to capital strategy and
shareholder value (6). The findings of the report are that the disclosure of all areas, except business
risk, on average is on a mediocre level.
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Credit risk (1) is the most developed area of disclosure in the banking sector. However, there still
exists room for improvement and KPMG relates that to the fact that not all surveyed banks did yet
apply the Basel II regulation. Indeed, the results show that financial institutions already applying
Basel II have a better quality in both quantitative and qualitative credit risk disclosure. Market risk (2)
and ALM and treasury risk (3) is generally mediocre. Gaps are found in the disclosure of risk
concentrations and in the disclosure on ALM practice and reporting. Business risk (4) is the least
developed risk disclosure area. About half of the banks provide inadequate disclosure of their
business risks. Many banks do not disclose whether they identify business risks at all and only a few
banks link these risks to their business strategies. Reputational risk, as stated by Basel II, is however
fairly well identified as a type of risk, indicating that regulatory requirements by some means drive
risk disclosure. The average operational risk (5) disclosure is also on a low level. Operational risks are
on average well defined, but the level of definition is often on a general level. Other deficiencies are
related to the disclosure of operational risk management, reporting and mitigation. The last
disclosure category, disclosure of issues related to risk and capital strategy and shareholder value (6)
is in general on a mediocre level. The dispersion of scores between institutions is fairly wide, which
means that all institutions disclose some information on the overall risk and capital management,
while the best ones provide good disclosure throughout the risk area (KPMG, 2008, p. 12-13).
4.3.2 Content analysis
Examining risk disclosures is often carried out by means of content analysis and more specific by
means of a sentence analysis. Content analysis is a method to study the content of communication.
In studies on risk disclosure, generally the written text in (parts of) the annual report is examined.
Studies on non-financial companies are Beretta and Bozzolan (2004), Lajili and Zeghal (2005), Linsley
and Shrives (2005b), Linsley and Shrives (2006), Linsley and Lawrence (2007), Amran et al. (2009) and
Michiels et al. (2009). There is only one study on financial firms using content analysis, by Linsley et
al. (2006). This is the most relevant study and a main fundament for this study and is first discussed.
Linsley et al. (2006)
The study of Linsley et al. (2006) examines risk disclosure practices within annual reports of Canadian
and UK banks. Their paper analyses and classifies the risk information communicated by the sample
banks and discusses the nature of the risk disclosure. A matched pair approach was adopted to
match nine Canadian banks listed within the ranking with UK banks of comparable size. Content
analysis was used to analyze and classify the risk disclosures within the annual reports. A total of
3,323 risk sentences were identified within the sample of annual reports. They were categorized in
credit risk, market risk, interest rate risk, operational risk, capital adequacy risk and risk management
34
policies. Furthermore they were characterized according to form (qualitative or quantitative), period
(past or future) and qualification (bad, neutral or good).
The highest numbers of disclosures fall within the credit risk area, followed by market risk and capital
adequacy risk. Market risk and credit risk are both financial risks, and it is therefore expected for
banks that these risks are dominant in risk disclosures. It differs however from the BCBS 2001 survey,
where four other disclosure categories were ranked more highly than credit risk. More consistent
with the BCBS 2001 survey are the rankings of market risk and capital adequacy risk. Furthermore,
operational risk disclosures are, on a relative basis, disclosed far less than market risk, credit risk and
capital adequacy risk. This result appears to be in contrast with the findings of the BCBS surveys
(2001, 2002 and 2003), where a noticeable increase occurred in the disclosure of operational risk.
The sentence characteristic that occurred most frequently is of the ‘qualitative/neutral/future’ type
(1,156 sentences). The majority of these disclosures consist of explanations of general risk
management policy. Such information does however not provide information about specific risks
that the bank faces and nor does it explain the actions the directors have taken to manage that risk.
Qualitative disclosures are much more disclosed than quantitative disclosures. Furthermore, there
are also more future disclosures than past disclosures. This could imply that there is greater
disclosure of future information. However, if we remove the general risk management policy
statements from the ‘qualitative/neutral/future’ type, this causes a reduction from 59% to 21%
future disclosures. The level of ‘quantitative/future’ type disclosures is very low and, according to the
authors, this is due to the fact that both quantitative and future disclosures are likely to be more
sensitive and therefore subject to higher levels of proprietary cost. Regarding the qualification
characteristic, 56% of the disclosures are neutral, 12% relate to bad news and 32% relate to good
news. Linsley et al. conclude that Canadian and US banks are willing to disclose some bad risk news,
but the difficulty is knowing whether there is further bad news that remains undisclosed. A final
noteworthy finding is that in a number of cases ‘quantitative and qualitative/bad news/past’
disclosure sentences are immediately followed by ‘qualitative/good news/future’ disclosure
sentences. The authors conclude that directors appeared to want to demonstrate that any ‘past/bad’
news had been acted upon and converted into good news.
Overall, the authors conclude that the usefulness of current disclosures is questioned as relatively
little quantitative risk information is disclosed and there is a very strong bias towards disclosing past
rather than future risk-related information.
35
Beretta and Bozzolan (2004)
Pioneers investigating risk disclosure were Beretta and Bozzolan (2004). They developed a framework
for the analysis of risk communication and an index to measure the quality of risk disclosure. Hence,
they applied their framework to a sample of nonfinancial companies listed on the Italian Stock
Exchange, focusing on the MD&A section only. Even though they identified 75 different risk items
being disclosed, they found that companies in general avoid communicating the expected impact in
quantitative terms of these risks and the economic direction of the firms. Furthermore, firms are also
reluctant to indicate whether the future risks disclosed will impact them, either positively or
negatively. They are more inclined to report past and present risks (Amran et al., 2009, p. 43).
Lajili and Zeghal (2005)
The study by Lajili and Zeghal (2005) examined risk information disclosures in the annual reports of
300 Canadian nonfinancial companies listed on the Toronto Stock Exchange. Employing content
analysis, they found a high degree of risk disclosure intensity, both mandatory and voluntary risk
management disclosures. However, the analytical power of such disclosures appeared to lack
uniformity, clarity and quantification, thus potentially limiting their usefulness. Related to the nature
of the disclosed risks, they found that financial risk was the most frequently disclosed risk and
include information relating to foreign currencies. Trailing behind financial risk is credit risk, followed
by market risk, which deals with companies’ reaction to competition. The authors conclude that
more formalized and comprehensive risk disclosures might be desirable in the future to effectively
reduce information asymmetries between management and stakeholders.
Linsley and Shrives (2005b)
In the UK, Linsley and Shrives (2005b, 2006) conducted two risk disclosures studies in the UK (United
Kingdom) context, by which the second paper was built upon the results of the first study. The first
paper examined risk information disclosed by UK public companies within their annual reports. Their
sample consisted of 79 nonfinancial companies listed in the FTSE 100 as on 1 January 2001. Using a
sentence-based approach they identified a total of 6,168 risk sentences. Consistent with the above
study by Lajili and Zeghal, financial risk was a dominant type of disclosure found in the sample, next
to strategic risk, which is followed by integrity risk. Most of the disclosure is qualitative in nature
which is again in line with the results of Lajili and Zeghal. An important conclusion is the fact that
directors appear to be willing to discuss external risks, but are more reluctant to discuss internal
risks. Overall, they found that the companies sampled are not providing a complete picture of the
risks they face. Minimal disclosure of quantified risk information is found and a significant proportion
36
of risk disclosures consist of generalized statements of risk policy. More useful is the released
forward-looking risk information.
Linsley and Shrives (2006)
In their second paper Linsley and Shrives (2006) continued with the results from the content analysis
of the above described risk disclosure research. They deepened their investigation into the
characteristics of the risk-related sentences, and disaggregated risk disclosure into good/bad,
future/past and monetary/non-monetary disclosure. They found very few monetary assessments of
risk information, but companies did exhibit a willingness to disclose forward-looking information.
Furthermore, statements of general risk management policy dominated and a lack of coherence in
the risk narratives was noticed. This implies, according to the authors, that a risk information gap
exists and consequently stakeholders are unable to adequately assess the risk profile of a company.
Linsley and Lawrence (2007)
In 2007, Linsley performed another risk disclosure study in the UK context together with Lawrence.
They used content analysis to identify risk disclosures in the annual reports of 2001 of the 25 largest
nonfinancial companies listed in the FTSE 100. From the 25 sample reports, they identified a total of
2,770 risk-related sentences. Hence, they tested these risk disclosures for readability and
obfuscation. In common, the level of readability of the risk disclosures is difficult or very difficult. The
authors conclude that, if the risk communication has to be improved, there is a need for greater
clarity when describing and discussing risks in the annual report.
Amran et al. (2009)
To date, research on risk disclosure has been undertaken mostly in the western setting. Amran et al.
(2009) provides a study on risk reporting by focusing on the Malaysian experience. Similar to
previous studies, they used content analysis to explore the availability of risk disclosure in a total of
100 listed nonfinancial companies’ annual reports. They identified a total of 2,023 risk-related
sentences, which consisted mainly of sentences about strategic risk (647) and operation risk (613).
Financial risk is a much less frequent disclosed risk, which is opposed to the findings of the studies of
Lajili and Zeghal (2005) and Linsley and Shrives (2005b). Furthermore, the total number of sentences
dedicated for discussion of risk information is very much less when compared to the study done by
Linsley and Shrives (2005b). According to the authors, this is due to the fact that disclosure reporting
by Malaysian companies is still at the infancy stage.
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Michiels et al. (2009)
The most recent study on risk reporting is done in the Belgian context by Michiels et al. (2009). They
also investigated risk disclosures using content analysis. Their sample consisted of 46 Belgian listed
nonfinancial companies. A total of 4,037 risk-related sentences were derived from the annual reports
and they found financial risk the most frequent disclosed risk, followed by operational risk.
Disclosures on business and legal risk are the least frequent disclosed risks.
4.3.3 Disclosure index
Next to Linsley et al. (2006), two other studies have examined disclosure by financial firms. Helbok
and Wagner (2003) performed an empirical study on operational risk disclosure and Hossain (2008)
investigated the extent of disclosure in common in annual reports of banking companies in India.
Helbok and Wagner (2003)
They performed a comprehensive study on operational risk and focused on the annual reports of the
biggest banks (by total assets) in Europe, Asia and North-America from 1998 to 2001. Their sample
consisted of 59 banks and to analyze the annual reports the authors counted words and pages
related to operational risk. Next a disclosure index was developed to judge about the quality of the
disclosure. Results show that both the extent (quantity) and the depth (quality) of operational risk
disclosure had grown. The total number of banks disclosing operational risk showed an enormous
growth and rose from 41% (1998) to 92% (2001). Furthermore, the amount of disclosure increased
by a factor of four. The findings were in line with the results of the BCBS surveys.
Hossain (2008)
The study of Hossain focuses on the banking sector in India and investigates the extent of disclosure
(both mandatory and voluntary) within the annual report. His sample consisted of 38 listed banks
and he investigated the annual reports of 2002 and 2003. To measure the extent of mandatory and
voluntary disclosure an unweighted disclosure index was used. Mandatory items were derived from
laws and regulation, listing rules and guidelines in the Indian context. Voluntary items were derived
from prior research and papers (guidelines, recommendations) of international financial institutions
and accounting bodies. It is noteworthy that among the identified voluntary items, major risk
information areas are defined. Examples are disclosure about general risk management, exposure to
market, credit and liquidity risk, interest rate risk and currency risk. This implies that main parts of
risk disclosure were not mandatory over the research period.
38
On average, banks published 60% of the total disclosure items of which 88% were mandatory and
25% were voluntary items. The author concluded that Indian banks are very compliant with the rules
regarding mandatory disclosure, but far behind in disclosing voluntary items. However, some
voluntary information, such as corporate social disclosure, corporate governance and risk-related
voluntary information, had been disclosed in the annual reports to an acceptable level, in the
author’s view.
4.3.4 Summarizing table
Table 2 shows a summary of the above described literature on the extent of risk disclosures. The next
paragraph will discuss the literature that relates the extent of risk disclosures to company specific
characteristics.
Table 2 The extent of risk disclosure
Author(s) Object of study Sample(size, country, period)
Methodology Results
Surveys in the financial sectorBCBS (2001)
Banks public disclosures in the annual report.
57 banks;member states;1999
Survey by means of questionnaire (104 questions).
In general, an increase in disclosures is noticed. Disclosure on liquidity, operational and legal risks increased significantly. Less prevalent were disclosures on credit risk modeling, credit derivatives and other credit enhancements.
BCBS (2002)
Banks public disclosures in the annual report.
55 banks;member states;2000
Survey by means of questionnaire (104 questions).
BCBS (2003)
Banks public disclosures in the annual report.
54 banks; member states;2001
Survey by means of questionnaire (104 questions).
KPMG (2008)
Analyze and define components and quality of best practice risk disclosure.
25 banks and14 insurance companies;Europe;2007
Survey framework: The Best Practice Risk Disclosure framework, developed by KPMG.
Disclosure of all risk areas are on an average level, except business risk. Credit risk is the most developed disclosure area. Risk disclosure can be improved significantly with limited effort.
Studies on financial firmsLinsley, Shrives,Crumpton(2006)
Analyze, classify and discuss risk disclosures in annual bank reports.
18 public listed banks;UK and Canada;2001
Matched pair analysis to match UK and Canadian banks. Content analysis to identify risk disclosures.
Credit risk is the most disclosed risk, followed by market risk and capital risk. The usefulness of current disclosures is questioned as quantitative and future risk information is disclosed much less often than qualitative and past information.
Helbok, Wagner (2003)
Examine the extent and quality of operational risk disclosure in annual bank reports.
59 banks; Europe, Asia and North-America; 1998-2001
Counting words and pages and a disclosure index to assess quantity and quality of operational risk disclosure.
Quantity and quality of operational risk disclosure has grown during the period. The number of banks disclosing operational risk doubled during the period.
39
Hossain (2008)
Examining the extent of disclosure in annual bank reports.
38 banks;India;2002-2003
An unweighted disclosure index to assess the extent of disclosure.
Indian banks are compliant to mandatory disclosure, but far behind in voluntary disclosure. Risk-related information is however at an acceptable level.
Studies on nonfinancial firmsBeretta, Bozzolan (2004)
Propose a multidimensional framework for the analysis of risk communication and applying it.
85 nonfinancial companies listed on the Italian Stock Exchange;Italy;2001
Content analysis to analyze voluntary disclosure in the MD&A section.
Companies in general avoid communicating the expected impact of risks in quantitative terms. Firms focus upon disclosing information on past and present risk, rather than future risks. Firms are also reluctant to indicate whether future risks disclosed will impact them, either positively or negatively.
Lajili, Zeghal (2005)
Examine risk information disclosures in the annual reports.
300 nonfinancial companies;Canada;1999
Content analysis to analyze risk information disclosures.
High degree of risk disclosure intensity, but the usefulness is questioned. Financial risk was most disclosed, followed by credit risk and market risk.
Linsley, Shrives (2005b; 2006)
Examine risk disclosures in the annual reports.
79 nonfinancial companies;UK;2000
Content analysis by means of a sentence-based approach to identify risk disclosures.
Strategic risk and financial risk dominant, followed by integrity risk. Most of the disclosure is qualitative in nature. Statements of general risk management policy dominate and companies are not providing a complete picture of the risks.
Linsley, Lawrence (2007)
Examine risk disclosures in the annual reports and test for readability and obfuscation.
25 largest non-financial companies;UK;2000
Content analysis to identify risk disclosures and the Flesch Reading Ease formula to test for readability and obfuscation.
Level of readability of risk disclosures varies from difficult to very difficult. There is a need for greater clarity when risks are described and discussed in the annual report.
Amran, Bin and Hassan (2009)
Explore the availability of risk disclosures in the annual reports.
100 nonfinancial companies;Malaysia;2005
Content analysis by means of a sentence-based approach to identify risk disclosures.
Strategic risk and operation risk are dominant types of disclosed risk, and financial risk much less. Total risk disclosure is very much less compared to Linsley and Shrives (2005b).
Michiels, Vande-maele, Vergauwen (2009)
Examining risk disclosures in the annual reports.
46 nonfinancial companies;Belgium;2006
Content analysis by means of a sentence-based approach to identify risk disclosures.
Financial risk is most disclosed, followed by operational risk. Disclosures on business and legal risks are the least frequent disclosed risks.
4.4 Factors that influence risk disclosure
This paragraph discusses the literature that relates the extent of risk disclosures to company specific
characteristics. First, studies on financial firms (Helbok and Wagner, 2003; Linsley et al., 2006 and
Hossain, 2008) are discussed as these are most relevant for this study. Second, studies on
40
nonfinancial firms are analyzed. Some of these studies are already partly addressed in the previous
paragraph. Finally, prior studies are reviewed to search for additional variables that can have a
relationship with disclosure in general and risk disclosure in specific.
4.4.1 Studies on financial firms
Helbok and Wagner (2003)
Next to investigating the extent and quality of operational risk disclosure by banks, Helbok and
Wagner tried to answer the question if there a relationship exists between bank characteristics and
disclosure. They chose two ratios as bank characteristics, equity ratio (equity / total assets, capturing
leverage) and profitability ratio (net profit / total assets) and used descriptive statistics and a logit
model to test whether the financial situation of the sampled banks could explain variation in
operational risk disclosure. Results show that relatively less well-capitalized (low equity ratio) and
less profitable banks (low profitability ratio) tend to disclose more on operational risk over the 1998
to 2001 period. Less capitalized banks have less of a capital cushion to withstand any large losses
from operational risk and therefore seem to have stronger incentives to convey to the market that
their operational risks are well managed and under control.
Linsley et al. (2006)
The exploratory study of Linsley et al. seeks to examine the association between the volume of risk
disclosures made by banks within their annual reports and potentially relevant variables. Potentially
relevant variables were identified as company size, relative profitability, level of risk and the quantity
of disclosed risk definitions. They chose total assets and market capitalization to measure bank size.
All these variables were expected to have a positive association with the level of risk disclosure. Both
measures of bank size and the quantity of disclosed risk definitions indeed showed a positive
correlation with the number of risk disclosures. However, there did not appear to be an association
between levels of risk disclosure and either bank profitability or the level of risk within the bank.
Hossain (2008)
The study of Hossain also investigates the association between company characteristics and the
extent of disclosure. The scores on the disclosure index were then tested against age, size and
profitability. Furthermore, Hossain tested the scores against the complexity of business (number of
subsidiaries) and assets-in-place, which is the proportion of fixed assets. Hossain argues that a higher
proportion of fixed assets lead to lower agency costs and consequently to lower disclosure. Finally,
board composition (proportion of non-executive directors) and market discipline (proportion of Non-
41
Performing-Assets and level of Capital-Adequacy-ratio) were tested for an association with the extent
of disclosure.
To investigate the effect of each variable on the disclosure level, Hossain set up a (OLS) regression
model. The multiple regression model is significant and explains 41% (the adjusted R2 is 0.411) in the
variation of the disclosure level. Age, complexity of business and assets-in-place were however not
statistically significant (at 10%). Size and profitability were significant at the 1% level. The latter
indicates that more profitable banking companies disclose significantly more financial information
than do less profitable ones. Board composition also turned out to be significant. The proportion of
non-executive directors on the board was positively related with the disclosure level. The NPA and
CAR ratio (as proxy for market discipline) were both significantly negatively related to the level of
disclosure. The reason may be the managements’ conservative motives. In order to comply with
ratios as set by the guidelines, banks may pursue low return investments in the hope that a reduction
in risk may compensate for the lowering of returns. Therefore, banks will unwillingly limit their
voluntary disclosure of information.
4.4.2 Studies on nonfinancial firms
Beretta and Bozzolan (2004)
Both company size and industry variables were tested against the extent and quality of risk
disclosure. Company size was found to be significant, but type of industry was not statistically
significant in explaining the amount of disclosure. However, the authors emphasize on the
importance of the type of industry, because the technological and market constraints exerted by the
competitive, industrial environment on business models significantly influence the risk profile of
companies. Moreover, the types of risks a company faces are strictly related to both the unique
critical-success factors and to the typical business models of an industry.
Lajili and Zeghal (2005)
Next to examining compulsory and voluntary risk reporting for a sample of companies listed on the
Canadian stock exchange, Lajili and Zeghal also tested for relationships between the quantity of
compulsory and voluntary risk reporting and firm-specific characteristics. Performing bivariate tests,
no relationship is found between the quantity of compulsory and voluntary risk reporting and firm
size (total assets), profitability (profits), beta (β), or leverage (debt/equity and debt/total assets).
42
Linsley and Shrives (2005b)
Linsley and Shrives tested for relationships between the number of risk disclosures within the annual
report and the level of risk within the company or the size of the company. A major difficulty is
determining an appropriate measure for a company’s risk level. Therefore, the authors used five
measures although all have limitations and none of them can be justified as superior to any other
measure. These measures were: asset cover, gearing ratio, beta factor, ratio of book value of equity
to market value of equity and QuiScore6. However, none of the risk measures showed a significant
association with the number of risk disclosures. Therefore higher risk companies are not naturally
disclosing more information in an effort to better explain the causes of their risks or how they are
being managed.
Next to the level of risk, Linsley and Shrives tested for the relationship between level of risk
disclosure and the size of the company. This relationship is thought to hold because larger companies
have greater numbers of stakeholders to whom they are accountable and as a consequence they
must provide more information. To measure company size, Linsley and Shrives used market value
and turnover. For both measures there was a statistically significant correlation existing between the
number of risk disclosures and the size variables.
Linsley and Shrives (2006)
In 2006, Linsley and Shrives performed another analysis on the gathered data in their previous study
(2005b). Again they tested for relationships between the level of risk disclosure and both company
size and level of risk within the company. Next to the five measures mentioned in the 2005b
research, the authors added two new measures for capturing the level of company risk: Innovest
EcoValue‘21™ ratings and the BiE (Business in the Community Index of Corporate Environmental
Engagement) index score. Both EcoValue‘21™ ratings and BiE Index scores aim to capture the level of
environmental risk of individual companies. For both measures, the authors find a positive
correlation with the number of risk disclosures. The authors carefully conclude that this implies that
companies with lower levels of environmental risk are disclosing greater amounts of risk information.
Abraham and Cox (2007)
The study by Abraham and Cox analyzes the determinants of narrative risk information in UK FTSE
100 annual reports. Ownership, governance and US listing characteristics are related to the extent of
risk information. They contributed to the research on risk reporting by identifying ownership and
6 QuiScores are developed and maintained by CRIF Decision Solutions Ltd. and are measures of the likelihood of company failure in the year following the date of calculation.
43
governance as determinants to risk reporting. Ownership and governance factors may play a vital
role in firm’s risk reporting because the annual report is prepared by the directors for share owners.
The relationship between risk disclosure and corporate ownership and governance is of interest to
regulators because institutional owners and independent directors are expected to reduce agency
problems and thus lessen the need for regulatory intervention in corporate reporting. Finally,
Abraham and Cox look whether the fact that UK companies that are dual listed in the US also have
influence on the extent of risk information. UK firms with such a listing are required to reconcile
financial statements to US accounting standards and submit this via a 20F disclosure to the SEC. US
reporting standards require additional risk disclosures compared to the UK regulation and therefore
the authors expect that UK firms listed in the US disclose a greater amount of risk disclosure in the
UK annual report.
Their sample consisted of 79 nonfinancial companies in the UK FTSE 100 index and they investigated
the 2002 annual reports. They performed content analysis on three types of narrative risk
information, business risk, financial risk and internal control risk. The results indicated that corporate
risk reporting is negatively related to share ownership by long-term institutions. Therefore the
authors conclude that this important class of institutional investor has investment preferences for
firms with a lower level of risk disclosure. Concerning governance, Abraham and Cox find both the
number of executive and the number of independent directors positively related to the level of
corporate risk reporting. This association was not found with the number of dependent nonexecutive
directors. This notion supports the emphasis on the independency of non-executive directors for
good corporate governance. Finally, the study found that UK firms with a US stock exchange listing
do disclose more risk information within the UK annual report than non-US-listed UK firms.
Hassan (2008)
Hassan performed a study in the United Arab Emirates context and his study seeks to explore the
relationship between UAE corporations’ characteristics and the level of corporate risk disclosure
(CRD). The chosen firm-specific characteristics are size, level of risk, industry type and the corporate
reserve. Results are drawn upon a sample of 41 corporations which was divided in a financial sector
(24 companies) and a nonfinancial sector (17 companies). The level of corporate risk disclosure for
each corporation is captured by a risk disclosure index which is based on accounting standards,
professional requirements, prior literature and the UAE regulatory framework.
The empirical findings show that corporate size is not significantly associated with the level of CRD, in
contrast with results of prior research. The corporate level of risk and corporate industry
44
membership are however significant in explaining the variation of CRD. The latter is consistent with
previous research, but the level of company risk is only scarcely found to be significant for the extent
of risk disclosure. Finally, corporate reserve is not significantly associated with the level of CRD.
Amran et al. (2009)
Besides investigating the extent of risk management disclosure in Malaysian annual reports, Amran
et al. also aim to empirically test the sampled companies’ characteristics against the extent of risk
disclosure. The following firm-specific characteristics were identified: product and geographical
diversification, size, type of industry and company level of risk. Performing multivariate analysis,
Amran et al.’s chosen variables were able to explain quite a lot of the variability in risk management
disclosure (the adjusted R2 was 0.433). None of the diversification variables were found to be
significant, however they were positively correlated, which is consistent with the hypothesis. The size
variable was found significant but leverage was not. This is in line with the results of the previous
studies. Finally, two of the eighth industries (infrastructure and technology industries) were found
significant, which could be, according to the authors, due to the nature of these industries.
Michiels et al. (2009)
In the Belgian context, Michiels et al. investigated also firm-specific determinants related to the
extent of risk disclosures. The identified variables were company size, profitability, level of company
risk, quality of the auditor and the presence of a risk committee and/or manager. Furthermore they
tested against the proportion of the number of non-executive directors in the board of directors.
Finally they test the extent of risk disclosures against the situations of one-tier and two-tier system
regarding the organizational structure.
The variables that they found significantly related to the extent of risk reporting are sales (as proxy of
size), profitability and beta (as proxy of the company risk level). Between size and risk reporting and
beta and risk reporting the relationship was positive, which means that companies with big sales
volumes and a higher systematic risk beta also release more risk-related information. The
relationship between risk reporting and profitability is negative, which is somewhat surprising
compared to results from previous research.
All other variables were found insignificantly related to risk reporting. Although the presence of a risk
committee and/or manager was found positively correlated in the Pearson correlation, this relation
disappeared in the multivariate regression. According to the authors, this means that the univariate
correlation between risk reporting and the presence of a risk manager/committee is driven by
45
company size. The multivariate regression model does however explain 31% (the adjusted R 2 was
0,305) of the variance in the total risk reporting score.
4.4.3 Other disclosure studies
Literature on disclosure has developed into a distinct branch of economic and accounting research.
There has been extensive research in the advanced and developing countries to measure the
corporate disclosure in financial and nonfinancial companies. A few studies will be reviewed to find
some additional variables that could influence disclosure levels.
Wallace and Naser (1995) found type of auditor significant in explaining variation in disclosure
indexes, a result that was not found by Michiels et al. (2009). In addition, scope of business was also
significantly related to the variation in disclosure levels, which means that firms classified as
conglomerates provide more disclosure than firms which are classified as non-conglomerates.
Liquidity ratios and outside shareholders’ interests were less useful in explaining variation in
disclosure indexes.
Jaggi and Low (2000) examined the impact of culture, market forces and legal system on financial
disclosures. Their results indicate that firms from common law countries are associated with higher
financial disclosures compared to firms from code law countries. Cultural values have however an
insignificant impact in common law countries, and mixed results appear in code law countries.
Haniffa and Cooke (2005) investigated the impact of culture and governance on corporate social
reporting in the Malaysian context. The ethnic background of directors and shareholders was used as
a proxy for culture. Corporate governance characteristics include board composition, multiple
directorships and type of shareholders. Their results indicate a significant positive relationship
between social disclosure and boards dominated by Malay directors, chair with multiple
directorships and foreign share ownership. The proportion of non-executive directors was predicted
to be positive, but was found negatively related to social disclosures. Control variables (size, multiple
listing and type of industry) were also significantly related to corporate social disclosure.
4.4.4 Summarizing table
Table 3 shows an overview of the discussed literature in this paragraph (except 4.4.3), about firm-
specific characteristics related to the extent of risk disclosure.
46
Table 3 Firm-specific variables and risk reporting
Author(s) Object of study Sample (size, country, period)
Methodology Results
(Risk) disclosure studies on financial firmsHelbok, Wagner (2003)
Relationship between bank characteristics and operational risk disclosure.
59 banks;Europe, Asia and North America; 1998-2001
Descriptive statistics and a logit model.
Less well-capitalized and less profitable banks tend to disclose more on operational risks.
Linsley, Shrives, Crumpton (2006)
Association between volume of risk disclosures and potentially relevant variables.
18 public listed banks;UK and Canada; 2001
Mann-Whitney U-test and Pearson’s rank correlation.
Bank size and total quantity of disclosed risk definitions were positively correlated with risk disclosure. No association found between levels of risk disclosure and either profitability or level of risk within the bank.
Hossain (2008)
Association between bank characteristics and the extent of disclosure.
38 banks; India2002-2003
Multiple regression model (OLS).
Size, profitability, board composition and market discipline were significantly related, but age, complexity of business and assets-in-place were not.
Risk disclosure studies on nonfinancial firmsBeretta, Bozzolan(2004)
Investigating the size and industry effect regarding the quantity of disclosure.
85 nonfinancial companies listed on the Italian Stock Exchange, Italy; 2001
Regression model for relative quantity, using one size variable and 6 industry variables.
Company size was found to be significant positively related. Type of industry was not significantly related in explaining the amount of disclosure.
Lajili, Zeghal (2005)
Relationships between quantity of risk reporting and firm-specific characteristics.
300 nonfinancial companies; Canada; 1999
Bivariate tests on the selected variables.
No relationships found between quantity of compulsory and voluntary risk reporting and firm size, profit, beta or leverage.
Linsley, Shrives (2005b)
Relationship between number of risk disclosures and firm-specific characteristics.
79 nonfinancial companies;UK;2000
Pearson correlation coefficients with two variables for size and five for level of risk.
Both size measures were statistically significant related with the number of risk disclosures. For all risk measures, no association was found.
Linsley, Shrives (2006)
Relationship between number of risk disclosures and environmental risk.
79 nonfinancial companies;UK;2000
Pearson correlation coefficients with two measures of environmental risk
Both measures show a positive correlation with the number of risk disclosures, implying that companies with lower levels of environmental risk are disclosing more risk information.
Abraham, Cox (2007)
Analyzing determinants of narrative risk information in the annual report.
79 nonfinancial companies;UK;2000
Regression model with defined variables regarding ownership, governance and US listing characteristics.
Risk reporting is negatively related to share ownership by long-term institutions. Number of executive and number of independent directors is positively related with risk reporting. Furthermore, US listed UK firms tend to disclose more.
47
Hassan (2008)
Explore relationship between corporate characteristics and the level of corporate risk disclosure.
24 financial and 17 nonfinancial companies;UAE;2005
Regression model with the following variables: size, risk level, industry type and level of reserves.
Corporate size and reserve are not significantly associated with the level of CRD. The level of risk and industry membership are however significant in explaining the variation of CRD.
Amran, Bin and Hassan (2009)
Empirically test the sampled companies’ characteristics against the extent of risk disclosure.
100 nonfinancial companies; Malaysia;2005
Regression model (multivariate analysis) with the following variables: size, type of industry, company risk level and diversification.
Company size was found significantly but leverage was not. None of the diversification variables were found to be significant. Two out of eight industries were, due to their nature, significant.
Michiels, Vande-maele, Vergauwen (2009)
Firm-specific determinants related to the extent of risk disclosures.
46 nonfinancial companies; Belgium;2006
Regression model and Pearson correlation, with size, profitability, risk level, quality of the auditor and governance.
Sales (size), profitability and beta (risk level) were found significantly related to the extent of risk reporting. All other variables were found insignificantly.
4.5 Usefulness of risk disclosure
Besides investigating the extent and drivers of risk reporting, other studies look specifically to the
usefulness of risk disclosure. Examples of such studies are Linsmeir et al. (2002) and Venkatachalam
(1996). These studies investigate the relationship between risk disclosure and the interest rates,
foreign currency exchange rates and commodity prices. The study by Linsmeir et al. (2002) provides
strong evidence of the usage of risk disclosure by investors. The researchers found that the
disclosure of information about market risks is useful in taking investments decisions as it reduces
the level of investor uncertainty.
4.6 Conclusion
The results of prior research on risk disclosure in both financial and nonfinancial firms have been
discussed in this chapter. Two streams of literature are important for this research: literature on the
extent of risk disclosure and literature on the firm-specific characteristics that can explain the
(variation in) the extent of risk disclosure. The most relevant studies within these streams are
summarized in table 2 and 3.
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5 Research Design
5.1 Introduction
In this chapter the research design is discussed, to begin with the sample selection in the next
paragraph. The research conducted in this study consists of two steps. First, risk disclosures in annual
reports are examined by means of content analysis to capture the extent and characteristics of
information about risk disclosed in the annual report. This method, its methodology and the reasons
why this method is adopted are therefore discussed in the third paragraph. Second, the gathered
data in the first step is examined by means of regression analysis, to test for relationships between
the extent of risk disclosure and potential explanatory variables. Therefore the fourth paragraph
develops hypotheses about these relationships, the fifth paragraph discusses the methodology of
regression analysis and presents the regression model. The last paragraph discusses the
measurement of the independent variables.
5.2 Sample selection
To select the banks to be examined in this research, the BankScope Financials database is used
(accessible via the Wharton Research database). Removing non-EU, non-listed and non-consolidated
bank (reports), a population of 217 banks remained. BankScope also recognizes different types of
specializations for each bank, for example commercial banks or investment banks. Different types of
banks can differ in their risk profile and in order to create a homogeneous sample, only three types
of specializations are considered: commercial banks (111), cooperative banks (25) and bank holdings
and holding companies (31). Other specializations were not taken into consideration to avoid that
they would affect the results (such as Mortgage banks, Investment banks, Islamic Banks,
Governmental Credit Institutions and Securities Firms). After that, twelve local Crédit Agricole
subsidiaries were removed from the sample, as they are subsidiaries of the French national Crédit
Agricole. Using the Ernst & Young sampling assistant tool in Excel, a number of 40 banks have been
selected from the number of remaining banks (155). The list of the final sample selection is showed
in appendix C. The EU area is chosen because of its harmonized accounting standards system (IFRSs).
The year 2007 is chosen because in that year the credit crunch occurred, resulting in turbulence on
the financial markets and volatility on the stock market, and thus may coincide with listed firms
placing greater value on risk disclosure. Furthermore, the increased regulation of IFRS 7 and Basel II
forces banks to disclose more risk information. All annual reports were with a year-end date of 31
December 2007, which ensures comparability of the annual reports that formed the basis for the
content analysis.
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5.3 Content analysis
Accounting researchers have increasingly focused their efforts on investigating disclosure, in
particular the determinants of disclosure and the capital market consequences of disclosure.
According to Beattie et al. (2004, p. 2), two principal ways of measuring disclosure have been
employed. The first approach has been to use subjective analyst disclosure rankings. This approach is
not without conceptual problems, the practical problem is availability. Rankings are scarce and often
only available in the United States. The second approach has been to analyze the content of
narratives with either researcher-constructed disclosure indices or content analysis (see for a
discussion of these methods Beattie et al., 2004, p. 4-9).
Beattie et al. (2004, p. 10) argue that the extant approaches to the analysis of accounting narratives
in annual reports suffer from two fundamental limitations. First, they are essentially one-
dimensional, whereas disclosure is a complex, multi-faceted concept. To overcome this limitation,
this study captures multiple dimensions of risk disclosure. The first dimension to be considered is
topic, which in this study consist of the major risk areas. Hence, specific risk information is being
nested within the defined risk categories. In addition to this, three type attributes are defined, based
upon the following dichotomous descriptors: past/future, quantitative/qualitative and
good/neutral/bad.
The second limitation is that many extant approaches are partial, either because they examine only
selected sections of the annual report or because they focus on particular issues or pre-selected
items. In my view, this is not a limitation of the approaches but a limitation of the respective studies,
caused by the decisions of the researchers. This study is about risk disclosure, so obviously only
attention is paid to risk information. Previous literature (see chapter 4) shows that risk information
can be find throughout the entire annual report, for example in the notes but also in the
management report. Mandatory accounting information is usually disclosed in the notes to the
financial statements, but IFRS 7 leaves companies free to choose where to disclose the related risk
information. Hence, this study has chosen to analyze the entire content of the annual reports in
order to avoid biased results from a too narrow focus. Furthermore, the annual report has been
defined as the ‘main disclosure vehicle’, concluding that it is the most comprehensive financial report
available to the public (Beretta and Bozzolan, 2004, p. 276). In addition, Lang and Lundholm (1993)
showed that the disclosure level in annual reports is positively correlated with the amount of
corporate disclosure communicated to the market and stakeholders using other media.
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Content analysis is a means of categorizing items of text. For valid inferences to be drawn, it is
important that the classification procedure is reliable and valid. Reliable means that different people
would code the text in the same way, and valid means that the variables generated from the
classification procedure represent what the researcher intended it to represent. Three types of
reliability can be identified: stability (the extent to which the same coder is consistent over time
when coding the same content); reproducibility or inter-coder reliability (the extent to which
different coders produce the same results when coding the same content); and accuracy (the extent
to which the classification of texts corresponds to a standard or norm) (Krippendorf, 1980, p. 130-
132). To improve reliability of content analysis, previous studies usually use more than one coder for
at least a part of the sample.
Weber (1985, p. 23-24) provides useful discussions regarding how to develop and test a coding
scheme. The basic steps are:
1. define the recording unit (e.g., word, sentence, theme);
2. define the categories (several key decisions);
3. test coding of a sample of text;
4. assess reliability;
5. revise coding rules (e.g., develop disambiguation rules);
6. repeat steps 3-5 until reliability is satisfactory;
7. code all text; and
8. assess achieved reliability.
Following step one, this research chose to measure the extent of disclosure of risk information by
counting risk and risk management sentences rather than words or pages. This is in line with usual
practice in previous disclosure studies using content analysis (e.g. Linsley et al., 2009 and others).
According to Milne and Adler (1999, p. 4), this unit of analysis is deemed more reliable as a coding
method than other units of analysis (e.g. words, paragraphs, pages). They criticize the use of words
since, by themselves, words do not convey any meaning unless referred to the sentences for their
proper contexts. Moreover, it is difficult to decide which words are considered as risk disclosure. Step
two is a step which involves several key choices to be made. The separate risk categories have to be
defined and the attributes that will be captured.
Prior literature is used to breakdown risks into relevant categories and to create an appropriate
classification scheme. The study of Linsley and Shrives (2005b, p. 298, on nonfinancial companies)
distinguished financial risk, operations risk, empowerment risk, information processing and
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technology risk, integrity risk and strategic risk. The study of Linsley et al. (2006, p. 273, on banks)
split up financial risk into credit risk, market risk and interest rate risk, apparently because of the
significance of these risks to financial firms. Next to these risks, operational risk, capital adequacy risk
and a special category for disclosure about risk management policies were distinguished. Using this
classification and other schemes of Amran et al. (2009, p. 53-54) and Michiels et al. (2009, p. 4), a
new classification scheme is developed that best reflects the relevant risk categories. Furthermore,
risk categories from theory (paragraph 3.8) and in the BCBS studies and a KPMG paper (paragraph
4.3.1) are considered. In short, starting from the categorization of Linsley et al. (2006), interest rate
risk is categorized under market risk. Furthermore, the categories liquidity risk, business risk and
legal risk are added. The risk classification model is presented in appendix D.
Along with the categorization of the risks, certain attributes of the risk-related sentences are
determined. Linsley et al. (2005b, p. 296) noted the following attributes:
(1) whether the risk sentence provided qualitative or quantitative information;
(2) whether good news, bad news or neutral news was being communicated; and
(3) whether the information related to the future or the past.
These attributes gives greater insight in the characteristics and are therefore adopted in this study.
Together with the risk categories and the above defined attributes, a coding grid is created, which
can be found in appendix E.
Step one and step two are important to carry out properly in order to acquire reliable results.
Therefore coding or decision rules need to be developed, in order to achieve a consistent coding
process and to avoid ambiguous and biased results. Step five was used to revise the decision rules.
Initially adopted the same decision rules as used by Linsley et al. (2006), but the author refined and
updated these as they were found too inadequate in their description. The set of decision rules can
be found in appendix F. In short, sentences are coded as risk disclosures if it is considered that the
reader is better informed about risks that have already had impact upon the company, or may in the
future have an impact upon the company, or if the reader is better informed about risk management
within the company. The word “risk” did not have to appear within any given sentence for it to be
identified as a risk disclosure sentence. If a sentence had more than one possible classification, the
information was classified into the category most emphasized within the sentence.
As the author is the sole writer on this study, the reliability of the study cannot be improved by using
more than one coder. However, the author did the following to improve the reliability of the coding
process and to confirm the understanding of the decision rules. Before the coding of the sample, the
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2001 annual reports from Northern Rock plc and LloydsTSB were coded. These annual reports were
included in the study of Linsley et al. (2006) and they coded respectively 77 and 181 risk disclosure
sentences. The author found respectively 81 and 189 risk disclosure sentences, resulting in a <5%
deviation from the results of Linsley et al. (2006), supporting the notion that the author has mastered
the coding process sufficiently.
Using the developed coding grid and decision rules, the author read each annual report and
identified all sentences providing risk or risk management information and coded each individual
risk-related sentence on this coding grid. The results can be found in paragraph 6.2. Appendix G
provides examples of risk sentences within the annual report and their categorization.
5.4 Hypotheses development
In this paragraph hypotheses are developed using prior research described in the previous chapter.
Firm-specific characteristics that are expected to influence risk disclosure levels are identified and a
prediction about the sign of the relationship is given.
5.4.1 Size
Many studies have managed to prove an association between company size and risk disclosure level
(Beretta and Bozzolan, 2004; Linsley and Shrives, 2005b, Linsley et al., 2006; Abraham and Cox, 2007;
Hossain, 2008; Amran et al., 2009 and Michiels et al., 2009). Lajili and Zeghal (2005) and Hassan
(2008) reported however a non-significant relationship between the two variables in their study. Size
is furthermore included in almost every disclosure study, either as a variable of interest or as a
control variable. As banks become larger, the number of stakeholders involved will also increase. To
meet the information needs of a larger group of stakeholders the bank’s burden of disclosure
becomes heavier. Therefore, the following hypothesis is developed:
H1: Ceteris paribus, there is a positive relationship between the size of the bank and the
extent of risk disclosure.
5.4.2 Profitability
Prior (risk) disclosure studies shows mixed results when testing for an association between the
company’s profitability and its disclosure level. No association is found by Linsley et al. (2006) and
Lajili and Zeghal (2005). Hossain (2008) found a positive association within banks but Helbok and
Wagner (2003) found a negative association. This is also found by Michiels et al. (2009) within
nonfinancial companies. According to Linsley et al. (2006) it could be argued that those banks that
53
are better at risk management will have higher levels of (relative) profitability and that they want to
signal their superior risk management abilities to the market place via disclosures in the annual
report. This potential link will be tested for in this study and therefore the second hypothesis is:
H2: Ceteris paribus, there is a positive relationship between the relative profitability of the
bank and the extent of risk disclosure.
5.4.3 Level of risk
Banks with higher levels of risk have a greater incentive to demonstrate that they are actively
monitoring and managing those risks and to ensure they are not penalized excessively by the market.
This can also be argued based upon stakeholder theory: a bank is expected to undertake more risk
disclosure in order to provide justification and explanation for what is happening in the firm.
Consequently, it may be argued that those banks with higher risk levels will disclose more risk
information in comparison to those with lower risk levels (Linsley et al., 2006, p. 274). Previous
studies did found a positive association between the level of risk and the extent of risk reporting
(Abraham and Cox, 2007; Hassan, 2008 and Michiels et al., 2009). The third hypothesis is therefore:
H3: Ceteris paribus, there is a positive relationship between the bank’s level of risk and the
extent of risk disclosure.
5.4.4 Multiple listing
Abraham and Cox found that UK listed companies with a US stock exchange listing do disclose more
risk information within the UK annual report than non-US-listed UK firms. According to them, this
supports two views. First, from an agency perspective it supports that greater disclosure is a method
by which managers can demonstrate to shareholders that they are acting optimally. Second, it
supports a transaction cost argument that firms have little reason not to disclose, for the additional
disclosure comes at zero marginal cost. Another study, by Haniffa and Cooke (2005) found a positive
relationship between the extent of corporate social disclosure and multiple listing as well. Banks that
are multiple listed could encounter a greater need for disclosure as their securities are distributed via
a more diverse network of exchanges. Consequently they have to deal with additional regulators (for
example the Securities and Exchange Commission in the US) and also with a larger group of
stakeholders (see also the first hypothesis). The fourth hypothesis is therefore:
H4: Ceteris paribus, the extent of risk disclosure is greater for banks with multiple listing
statuses.
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5.4.5 Credit ratings
Credit rating agencies are firms that assess the likelihood that issuers of debt will make full and
timely payment of their obligation. The major agencies are Moody’s, Standard and Poor’s and Fitch.
These ratings estimate the credit worthiness of an individual, corporation or a country and are
typically assigned on an alpha or numeric basis (e.g. 1-5 or A-E) (Stern and Feldman, 2004). The
ratings are often interpreted as discrete indicators of quality. Prior research did not yet link credit
ratings to the extent of risk disclosure and therefore this hypothesis is based upon own postulations.
Higher credit ratings indicate that banks are more trustworthy than banks with lower credit ratings.
Moreover, higher credit ratings indicate that banks have a better risk management as they are
assumed to be safer to invest in than banks with lower credit ratings. To show their superior risk
management abilities and to maintain or gain additional market confidence, banks with higher credit
ratings are expected to release more risk disclosure. Therefore the fifth hypothesis is as follows:
H5: Ceteris paribus, the extent of risk disclosure is greater for banks with higher credit ratings.
5.4.6 Organizational structure
The next two hypotheses relate corporate governance to the extent of risk reporting. As said in
paragraph 2.7, due to the variety in corporate governance structures in the sample area (EU), it is
difficult to relate corporate governance variables to the extent of risk disclosure. Although
acknowledging this, the BCBS 1999 paper (‘Enhancing corporate governance for banking
organizations’) describes four important forms of oversight that should be included in the
organizational structure of any bank in order to ensure the appropriate checks and balances. The first
one is “(1) oversight by the board of directors or supervisory board (…)” (BCBS, 1999, II.11). Regarding
their organizational structure, companies can have a one-tier structure (board of directors with both
executive and non-executive directors) or a two-tier structure (board of directors with only executive
directors and an additional supervisory board with non-executive directors). The BCBS did not give an
indication about which structure should be preferred regarding corporate governance, but prior
research does. Fama and Jensen (1983) argue that in a company with a one-tier structure, there is no
separation between decision authorization and decision control. Agency theory further proposes that
within a one-tier structure the supervisory function of the board of directors is reduced, as argued by
Michiels et al (2009, p. 6). Therefore, it could be argued that a two-tier structure leads to stronger
corporate governance and hence, to more risk disclosure. The sixth hypothesis is formulated as
follows:
H6: Ceteris paribus, the extent of risk disclosure is greater for banks with a two-tier structure.
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5.4.7 Board composition
Alongside the emphasis on the supervisory function within a firm, the BCBS paper underlines that
those individuals keeping oversight should not be involved in the day-to-day running of the various
business areas (1999, II.11). As the BCBS relates this aspect of board composition to strong corporate
governance, prior research has linked strong corporate governance to improved risk disclosure. Both
Abraham and Cox (2007) and Michiels et al. (2009) tested for board composition related to the
extent of risk disclosure. Since the approval of the annual report is done by the board of directors,
the composition of this board could influence the extent of risk reporting. Following the BCBS (1999)
notion, Abraham and Cox (2007, p. 231) hypothesize that the proportion of non-executive directors
in the board is positively related to risk disclosure. Executive board directors, as fulltime employees
of the firm, are corporate insiders. By working alongside managers, it may prove difficult for
executive directors to also monitor managers’ actions (Fama and Jensen, 1983). Agency theory
therefore proposes that executive directors have insufficient incentives regarding disclosure,
including risk disclosure. Michiels et al. (2009) state that due to the presence of non-executive
directors agency costs are likely to fall and this could be reflected in more extensive reporting.
Abraham and Cox (2007) did indeed find evidence for their reasoning, but Michiels et al. (2009) did
not. This hypothesis is only applicable for banks with a one-tier structure, having one board of
directors with both executive and non-executive directors. The seventh hypothesis is formulated as
follows:
H7: Ceteris paribus, there is a positive relationship between the proportion of non-executive
board directors and the extent of risk disclosure.
5.5 Regression analysis
This study uses multiple regressions in assessing the variability of the extent of risk disclosure. This
statistical method has been widely used in previous research (Haniffa and Cooke, 2005; Amran et al.,
2009 and Michiels et al., 2009). The regression model that is adopted to test the developed
hypotheses is the following:
RDSCORE=α 0+β1∗SIZE+β2∗PROF+β3∗LEV+β4∗ML+ β5∗CR+β6∗TIER+β7∗NONEXEC+ε
56
RDSCORE = number of sentences related to risks
SIZE = bank size in total assets (in millions US$)
PROF = bank’s profitability in return on (average) assets
LEV = bank’s level of risk (leverage as proxy)
ML = bank’s multiple listing (1 if a bank is multiple listed, 0 if not)
CR = bank’s long-term credit rating (scale variable)
TIER = bank’s organizational structure (1 if it is two-tier, 0 if it is one-tier)
NONEXEC = proportion of non-executive board directors divided by total board directors
In executing the regression analysis, the model needs to be slightly adapted. The reason is that the
variable TIER and the variable NONEXEC are dependent upon each other (NONEXEC has only a value
when the TIER value amounts 0). This problem is solved by first execute the regression analysis
without adding NONEXEC, but testing for all other variables. After that, to be able to test the variable
NONEXEC, the variable TIER is removed and the variable NONEXEC is added.
Before executing regression analysis, attention needs to be paid to the structure of the data. Cooke
(1998, p. 209). The problem of multicollinearity has to be determined. Transformation of the data is
possible to overcome non-normality. Another option recommended by Cooke (1998, p. 209) is using
Rank Regression. The data analysis in the next chapter deals with these issues.
5.6 Independent variable definition
The following independent variables need to be measured: size, profitability, level of risk, multiple
listing, organizational structure and board composition.
Size
Previous disclosure studies have measured size in different ways including turnover, total assets,
employee numbers and market capitalization. According to Hackston and Milne (1996) there is no
theoretical reason to favor one measure over another. Furthermore, prior research shows that
turnover, total assets and market capitalization are all found significantly related to the extent of risk
reporting. However, Linsley et al. (2006) argue that turnover is an inappropriate measure for the size
of banks as their profits do not derive from sales in the same way that the profits of, for example, a
manufacturing company derive from sales. Furthermore, in the author’s opinion, the accuracy of
market capitalization as a proxy for size may be reduced by turbulent market movements. Therefore
this study uses total assets to measure bank size. BankScope Financials database is the source of this
variable.
57
Profitability
A common proxy to measure relative profitability is the return on assets ratio. This proxy has been
used in all previous risk disclosure studies that examined the association of relative profitability with
the extent of risk reporting. BankScope Financials database contains the variable ‘return on average
assets’ and this variable is used.
Level of risk
Measuring the level of risk within a bank is problematical as there is no single measure that truly
encapsulates a bank’s risk level. Beta factor (from the CAPM model) and leverage (the ratio of total
debt to total assets) are the most used indicators of the level of company risk. Furthermore, asset
cover, gearing ratio, ratio of book value of equity to market value of equity and QuiScore are used
(Linsley and Shrives, 2005b). BankScope Financials database contains the following ratio describing
leverage: total equity divided by total assets. A low percentage indicates a high risk and vice versa.
Multiple listing
Manually the sampled banks will be checked whether they are multiple listed on other stock
exchanges within the European Union or elsewhere. For every bank this information was found
within the annual report.
Credit ratings
For the majority of the sample the credit ratings during 2007 could be gathered from the annual
report. In some cases, company websites (with the aid of Google) provided the information. The
credit ratings were found to be AA (highest) or BB (lowest) or in between. The rankings were
converted to a numeric scale. To match credit ratings of Standard & Poor’s with comparable ratings
from Moody’s and Fitch, an information table called “Long-term Rating Scales Comparison” provided
by the Bank of International Settlements was used (provided on their website).
Organizational structure
Based upon the annual report, banks will be checked if they have a two-tier structure (both board of
directors and supervisory board) or a one-tier structure (only a board of directors with both
executive and non-executive directors). This information was gathered manually from the annual
report or other documents, for example registration documents on company websites.
58
Board composition
The number of non-executive board directors compared to the executive board directors. Again,
annual reports, registration documents, press releases and other internet sources were used to find
this data.
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6 Analysis and Interpretation of the Results
6.1 Introduction
This chapter analyzes and interprets the results of the empirical research. The following questions
are answered in this chapter:
What are the risk disclosure practices of European banks in 2007?
What firm-specific characteristics are related to the extent of risk disclosures?
6.2 Descriptive statistics of the sample
The sample consisted of 40 public listed banks from the European Union Member States. The
European Union consists of 27 countries, of which 21 are represent in the sample selection. The
countries not represent in the sample are: Luxembourg, Finland, Romania, Hungary, Estonia and
Latvia. Italy represents most banks (6), before United Kingdom, Germany, France, Denmark and
Greece (all 3). The biggest bank (measured in total assets) is Deutsche Bank AG from Germany and
the smallest bank is FIMBank Plc from Malta. For more information, see the list in Appendix C.
6.3 Part I: Risk disclosure practices
6.3.1 Risk disclosure score
A total of 10,329 risk sentences were identified within the sample of annual reports. Table 4 shows
the coding grid containing the risk sentence disclosures for the total sample of banks. Barclays plc
(United Kingdom) had the highest risk disclosure score of 753 sentences, where Bank of Attica SA
(Greece) had the lowest risk disclosure score, 40 sentences. Appendix H shows the risk disclosure
score for the individual banks of the sample and appendix G provides examples of risk sentences and
their categorization.
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Table 4 Number of risk sentence disclosures for the sample of banks
Market risk
Credit risk
Liquidity risk
Oper-ational risk
Business risk
Legal risk
Capital struc..1
Risk mgt..2
Total
Text disclosure sentence characteristics
1 2 3 4 5 6 7 8
Quantitative Good Future A 29 4 0 0 2 0 0 0 35Quantitative Bad Future B 24 5 0 0 3 6 0 0 38Quantitative Neutral Future C 18 8 5 6 4 2 11 1 55Qualitative Good Future D 23 39 5 1 84 1 2 13 168Qualitative Bad Future E 18 22 3 0 56 3 2 0 104Qualitative Neutral Future F 1651 2030 702 597 184 203 333 875 6575Quantitative Good Past G 53 59 9 1 5 0 2 1 130Quantitative Bad Past H 48 63 9 24 34 1 4 0 183Quantitative Neutral Past I 546 781 177 63 28 4 186 15 1800Qualitative Good Past J 17 51 29 6 99 4 15 24 245Qualitative Bad Past K 24 25 7 8 65 18 6 0 153Qualitative Neutral Past L 174 183 80 98 71 40 99 98 843
Total 2625 3270 1026 804 635 282 660 1027 103291 Capital structure and adequacy risk; 2 Risk management frameworks and policies
The average risk disclosure score of the sampled banks is 258 risk sentences. Linsley et al. (2006)
found in 2001 annual reports of 18 English/Canadian banks on average 185 risk sentences. This
shows that the 2007 annual reports investigated in this study show a significant increase in risk
reporting measured in risk sentences. This can be explained by the increased demands of the
regulatory environment, the introduction of IFRS 7 and Basel II, and furthermore supports the notion
that there is an increase in the awareness of bank directors to disclose proper risk disclosures.
Other studies measuring risk disclosures sentences (see paragraph 4.3.2) varied from an average of
20 (Amran et al., 2009, Malaysian companies) to 111 (Linsley and Lawrence, 2007). These studies
were on non-financial companies, which explain the lower averages, compared to financial
companies. Banks are in the business of risk and are therefore expected to release more risk-related
information to the capital market.
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6.3.2 Risk categories
Market risk Credit risk Liquidity risk Operational risk
Business risk Legal risk Capital structure and ade-
quacy risk
Risk mgt frameworks and policies
0
500
1000
1500
2000
2500
3000
3500
2625
3270
1026
804635
282
660
1027
Num
ber o
f disc
losu
res
Figure 4 Number of disclosures in the different risk categories
Figure 4 reports the defined risk categories into which the risk disclosures were coded. Credit risk is
the most disclosed risk category, which is a consistent finding compared to other studies. Linsley et
al. (2006) found credit risk to be the dominant risk category, amounting about 37% of total risk
disclosure, compared to 32% of this study. Banks are essentially lending institutions and therefore
this is a significant risk requiring appropriate disclosures. The KPMG survey in 2008 confirms that
credit risk is the most developed area of disclosure. In comparison with the BCBS 2001 survey, credit
risk is not found to be the dominant disclosure area. This can however be explained by the fact that
the BCBS 2001 survey focuses on disclosure in common, not specifically on risk disclosure.
Credit risk is followed by market risk and together they dominate the risk disclosures in this study
(for about 57%). This result is in line with Linsley et al. (2006) and KPMG (2008), where market risk is
the second most disclosed risk area. Interest rate risk in this study is categorized under market risk,
where Linsley et al. (2006) distinguished these risks from each other. However, if their respective
scores are combined, the rankings do not change. In studies on non-financial firms, usually financial
risk is the most disclosed area (Lajili and Zeghal, 2005; Linsley and Shrives, 2005b; Michiels et al.,
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2009). Once again, this is consistent with these results, since financial risk in these studies includes
credit and market risk.
The remaining risks are far less disclosed than credit and market risk. Basel II requires significant
disclosures regarding operational risk (next to credit and market risks). Consequently, KPMG (2008)
defined the regulatory benchmark of operational risk relatively high, but found the average of
operational risk disclosure to be surprisingly low. This study also finds a low level of operational risk
disclosure, as it is only the fifth largest risk disclosure category. For example, there is more
information disclosed on liquidity risk. An explanation could be that banks are giving additional
attention to liquidity risk (management), to ensure readers that the effects of the credit crunch and
the resulting instability of the financial markets are under control and effectively mitigated. General
statements about risk management frameworks and policies amount to about 10% of the risk
disclosure, followed by risk disclosure regarding capital structure and adequacy risk. This type of risk
disclosure contains mainly information about capital ratios (and capital management), in essence an
indicator of the strength of a bank to deal with deteriorating economic circumstances. Compared to
the KPMG (2008) results, which reveal that risks related to capital strategy are on average on a
mediocre level, these results seem consistent.
The category business risk is absent in the study of Linsley et al. (2006), but generally acknowledged
as a separate risk area in the other risk disclosure studies. This type of risk disclosure contains
information about risks related to the macro-economic environment and strategic decisions. In this
study, information on the credit crunch and turbulence on the financial markets (in the second half
of 2007) mainly contributed to this risk disclosure category. The author found that almost all sampled
banks disclosed information about the credit crunch and some provided thorough analyses and
explanations what exactly occurred. However, these risk disclosures lacked detailed information
about what consequences these market circumstances would have upon the company. Instead,
readers were assured about proper risk management practices which were fully able to deal with
those risks. KPMG (2008) finds business risk to be the weakest disclosure area, as many banks do not
disclose whether they identify business risks at all, and only a few banks link these risks to their
business strategies. This study also finds banks to be reluctant to identify and distinguish business
risk and therefore confirm the KPMG findings. The least frequent disclosed risk is legal risk. One other
study, identifying legal risk as a separate risk disclosure area (Michiels et al., 2009) found the same
results.
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6.3.3 Risk characteristics
Next to the categorization of risks, also certain characteristics were investigated. Table 5 provides the
characteristics of risk disclosures, their total numbers and proportion.
Table 5 Summary of characteristics of risk disclosures
Characteristic Total number of disclosures
Proportion (%)
Qualitative disclosures 8,088 78.3Quantitative disclosures 2,241 21.7 Future disclosures 6,975 67.5Past disclosures 3,354 32.5
Good news disclosures 578 5.6Neutral news disclosures 9,273 89.8Bad news disclosures 478 4.6
The split-up between qualitative and quantitative information shows that approximately 78% of the
defined disclosures were qualitative and only 22% quantitative. Linsley et al. (2006) found this ratio
to be 67% versus 33%. Quantitative risk information is recognized to be more useful than qualitative
information, since the disclosure of the potential size of a risk puts the reader in a better position to
understand its significance. The majority of the quantified risk information is from the credit and
market risk category, the most regulated disclosure areas. It is therefore a surprise that the
percentage of quantitative information dropped compared to the Linsley et al. (2006) study, since
the average risk disclosure significantly has increased and the introduction of IFRS 7 and Basel II
require specifically quantitative risk disclosure. A possible explanation is that the number of
qualitative disclosures increased faster than the number of quantitative disclosures. This would result
in a relatively lower ratio even if the absolute number of quantitative disclosures increased. Another
explanation for the lower scores of quantitative is related to the fact that risks are inherently difficult
to quantify. Hence, directors may be reluctant to provide quantitative information against which they
may eventually be judged and held to account. Additionally, quantified risk information may be
highly sensitive and therefore subject to higher levels of proprietary costs (Linsley et al., 2006, p.
276). Linsley and Shrives (2005b) found in their study on non-financial firms also minimal disclosure
of quantified risk information.
It can be seen from table 4 that the sentence characteristic occurring most frequently is of the
‘qualitative/neutral/future’ type (6,575). The majority of these disclosures contain information and
explanations about general risk management policy. They are coded as ‘future’ information on the
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basis that they discuss internal control and risk management systems that will be remaining in place.
For example, the annual report of Allied Irish Banks states about risk management in general (p. 32,
coded as F8): “AIB has adopted an Enterprise Risk Management (“ERM”) approach to identify, assess
and manage risk”. Another example found in this report is about a risk management policy with
respect to an individual risk category (p. 38, coded as F1): “The Group uses a simulation tool to
estimate possible changes in future market values and computes the credit exposure to a high level of
statistical significance.” Linsley et al. (2006) found this type to be dominating as well, but questioned
the usefulness of this type of disclosure. They argue that, although these disclosures reassure the
reader that risk management systems are in place, it does not provide information about specific
risks that the bank faces and nor does it explain the actions the directors have taken to manage that
risk. The results in this study are however different interpreted, as the author did not have this
impression during the empirical research. On one hand, general and sometimes vague risk
management policies were indeed disclosed (category 8, table 4). For example, the annual report of
Bank of Attica states (p. 25): “Taking into consideration international best practices, Attica Bank uses
modern methods to manage and monitor the risks involved in its activities.” . On the other hand, in
many cases general statements were followed by explanations about risk assessment, risk
measurement/quantification, risk controlling and risk monitoring, regarding the different risk
categories.
Just as quantitative risk information is usually considered to possess greater value than qualitative
information, so is future (forward-looking) risk information generally considered to be more useful
than past risk information. Approximately 68% of the defined risk disclosures were categorized as
future information and 33% as past information. These results seem to show that companies exhibit
a willingness to disclose future information. However, Linsley et al. (2006) notice that the majority of
future disclosures result from the ‘qualitative/neutral/future’ type, consisting largely of general
policy disclosures. Therefore, if this type is removed from the total of future disclosures, the
percentage future information drops from 68% to 11%, showing that future information is far less
disclosed than past information. Again, future disclosures are likely to be more sensitive and hence
that may explain why directors disclose them less frequently. This is confirmed by looking at the total
of ‘quantified/future’ information: this amount to only 1.2% of the total risk disclosures.
Table 5 also reveals that the number of neutral risk disclosures forms the majority (90%) of the
disclosures, compared to bad and good disclosures. It may be expected that directors will prefer to
present positive information and therefore there will be more good news risk disclosures. These
results are similar compared to Linsley et al. (2006) and Linsley and Shrives (2005b). That neutral
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disclosures are dominant is according to Linsley and Shrives (2005b, p. 301) symptomatic for
companies. They release significant amounts of rather insipid general policy statements to the
market place, concerned with internal controls and risk management systems. The level of good and
bad news disclosures are comparable, indicating that directors cannot just choose to withhold bad
news. For example, poor financial results may require them to explain where risks have arisen with
adverse impacts (Linsley and Shrives, 2005b, p. 301). Although the banks show willingness to disclose
bad risk news, the difficulty is knowing whether there is further bad news that remains undisclosed
(Linsley et al., 2006, p. 277).
6.3.4 Conclusion
Compared to earlier studies measuring the risk disclosure score (in sentences), this study shows the
highest average, indicating that banks are disclosing more risk information in the annual report than
a few years earlier. Analyzing the different risk categories shows that credit and market risk are the
most developed risk disclosure areas. Since these risk areas are heavily regulated by the introduction
of IFRS 7 and Basel II this indicates that regulatory requirements drive risk disclosure to a large
degree. The examination of the characteristics of the risk disclosures revealed that it can be
questioned whether the increase in disclosure has led to more useful disclosure. The majority of the
risk disclosures is still qualitative, past and neutral. Relatively little quantitative and future risk
information is disclosed.
6.4 Part II: Regression analysis
6.4.1 Data analysis
This paragraph analyzes the data of the variables used in the regression analysis (table 6). Before
using multiple regression analysis, Cooke (1998, p. 209) argues that scholars should pay attention to
the structure of the data and consider the appropriateness of transformations. Data should be
screened to assess the impact of distribution problems of skewness and kurtosis, as well as problems
of outliers and non-linearity. A common measure to test for non-normality is the so-called
Kolmogorov-Smirnov test. This test was for the risk disclosure score, size (total assets), profitability
(roaa) and leverage significant. Visual inspection of the data confirmed non-normality. Therefore, the
data was transformed using the natural logarithm. After the transformation, the problems of
skewness, kurtosis and the outliers had been greatly reduced. Performing the K-S test again showed
no significance anymore on the independent variables. Table 6 provides the descriptive statistics of
the original variables and the transformed variables.
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Table 6 Descriptive statistics of the dependent and independent variables
Unit of measurement
N Min. Max. Mean S.D. Non-normality1
Skewness/ Kurtosis
Out-liers
Dependent variableRisk disclosure score (RDSCORE)
Sentences 40 40 753 258 176.50 Yes 1.5231.960
3
Risk disclosure score (LNRDSCORE)
Log of sentences 40 3.69 6.62 5.35 0.65 No -0.1150.308
1
Panel A: Independent continuous variablesSize (SIZE) Total assets US$ (in
millions)40 571 2,833,804 470,906 863,257 Yes 1.770
1.6098
Size (LNSIZE) Log of total assets US$ (in millions)
40 6.35 14.86 10.66 2.51 No 0.334-1.010
0
Profitability (PROF)
Return on average assets (ROAA)
40 -1.07 5,07 1.14 0.94 Yes 1.8417.740
3
Profitability (LNPROF)
Log of return on average assets
40 -1.83 1.62 -0.038 0.66 No -0.2420.781
2
Leverage (LEV) Total equity / total assets
40 0.02 0.33 0.08 0.06 Yes 2.5519.254
3
Leverage (LNLEV) Log of total equity / total assets
40 -3.87 -1.12 -2.69 0.60 No 0.0410.361
1
Board composition (NONEXEC)
Non-exec. directors / total directors
26 0.45 0.88 0.70 0.12 No -0.552-0.453
0
1 using the Kolmogorov-Smirnov test (using p. < 0.05)
Panel B: Independent categorical variablesMultiple listing (ML)
Dummy (1=yes, 0=no)
40 0 1 0.25 0.44
Credit Rating (CR_TF)
Scale 1-6 standing for AAA to B
40 2 5 3.05 0.96
Organizational structure (TIER)
Dummy (0=one-tier, 1=two-tier)
40 0 1 0.35 0.48
6.4.2 Multiple regression
In SPSS a multiple linear regression was performed to identify (in)significant relationships between
the dependent and the independent variables. Multiple regression analysis estimates the effect from
each individual independent variable upon the dependent variable, using the input data. Ordinary
Least Square (OLS) is a common used method in applying linear regression and is standard used in
SPSS. Cooke (1998, p. 4) presents Rank Regression analysis as an alternative for the conventional
OLS. The advantage of Rank Regression is that it yields distribution-free test statistics. Table 6 shows
that the original data did not meet the normal distribution requirements for linear regression. To
back-up results from the transformation using the natural logarithm, a Rank Regression analysis was
performed. In this regression technique, both the dependent and independent variables (excluding
TIER, ML and CR_TF, as these are dummy variables) are replaced with their corresponding ranks.
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Table 7 gives the model summary and the coefficients table from both regression analysis. The
analytical power of both models to predict its outcomes seems very powerful. The R square amounts
to 0.720 for the OLS model and 0.734 for the Rank Regression model. This means that the models
explain respectively 72% and 73.4% of the variation in risk disclosure, using the data from the
independent variables as predictor. The adjusted R square gives an idea about how well the models
generalize. These numbers are very high, indicating the model is accurately explaining the variance in
risk disclosure.
Table 7 Regression analyses
Model 1 Model 2Regression using… natural logarithm ranked data
Model summaryR 0.849 0.857R Square 0.720 0.734Adjusted R Square 0.669 0.686Durbin-Watson 1.684 1.857
Independent variables1
Size 0.205(3.784)*
0.769(4.284)*
Profitability 0.134(0.790)
0.071(0.537)
Leverage -0.007(-0.029)
-0.034(-0.183)
Multiple Listing 0.133(0.665)
3.353(1.008)
Credit Rating -0.064(-0.631)
-0.263(-0.147)
Tier Structure 0.170(1.241)
1.738(0.738)
Added after removing TIERNon-executive ratio (n=26) -1.130
(-1.404)-0.171
(-0.779)1The upper figures for each variable are beta coefficients and the lower figures are the t-statistics.* significant at the 5% level.
To test the non-existence of autocorrelation (i.e. the assumption of independent errors), the Durbin-
Watson statistic was utilized. A value less than 1 or greater than 3 should pose a problem, and the
closer to 2 the value is the better the model. The Durbin-Watson statistics are 1,684 and 1,857,
indicating there are no validity problems of both models.
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As stated in chapter 5, the variable NONEXEC is not included in the initial regression models. The
reason is that NONEXEC only has a value when the TIER variable (organizational structure) amounts
to 0 (i.e., has a one-tier structure). Out of the 40 cases, 26 banks have a one-tier system and
therefore there are only 26 values for NONEXEC. If the regression model was executed with
NONEXEC, the 14 cases missing NONEXEC values would be removed, and accordingly TIER would be
removed, as this variable would be constant (i.e, amounts to 0 in all cases). Therefore, NONEXEC is
not added in testing the models here described. However, to be able to test the hypothesis relating
to NONEXEC, the regression models are executed again without the TIER variable but this time with
the NONEXEC variable. Table 7 also shows the computed coefficient and t-statistic for the NONEXEC
variable.
The beta coefficients indicate the relationship between the dependent variable (risk disclosure score)
and each of the independent input variables. If this coefficient value is positive, this means that there
is a positive relationship between the dependent and independent variable. For example, in model 1
when size (LNSIZE) increases with 1, risk disclosure (LNRDSCORE) increases with 0,205. The
regression analysis also shows whether multicollinearity (correlation between independent variables)
is a problem. A common thumb rule in interpreting these statistics is that values of Tolerance smaller
than 0.1 and VIF values bigger than 10 are a strong indication of the existence of multicollinearity
(Hassan, 2009, p 677). The values in both models are within this range, indicating no significant effect
of multicollinearity (for the data, see the SPSS output in Appendix I).
6.4.3 Interpretation of the results
This paragraph interprets the output of the multiple regression regarding the computed beta
coefficients related to each independent variable (see Table 7).
The coefficients and the significance of the t-test show whether the model supports the pre-
developed hypotheses. The positive significant coefficient between size and risk disclosure confirms
hypothesis 1 (H1). Large banks disclose more about their risks than small banks. It supports the
positive accounting theory regarding the political cost hypothesis, when we apply this hypothesis
towards risk disclosure. Furthermore, it supports the stakeholder theory. To meet information needs
of a large group of stakeholders, the bank’s burden of disclosure becomes heavier. Finally, it confirms
earlier findings of Beretta and Bozzolan (2004), Linsley and Shrives (2005b), Linsley et al. (2006),
Abraham and Cox (2007), Hossain (2008), Amran et al. (2009) and Michiels et al. (2009).
69
No significant relationship is found between probability and risk disclosure. Therefore, there is no
support for hypothesis 2 (H2), although the positive beta coefficient is consistent with the theoretical
reasoning of the hypothesis. In earlier studies theoretical constructs about the relationship between
relative profitability and risk disclosure have been developed, but generally these are not empirically
confirmed. However, a few studies found significant relationships, either positive or negative
(Hossain, 2008; Helbok and Wagner, 2003; Michiels et al., 2009). A possible explanation that this
study did not find a significant relationship might be due to the consequences of the financial crisis.
Massive write-downs on certain portfolios led to major losses at certain European banks. Hence, this
influenced net income, one of the two elements in the profitability ratio return on assets. As a result,
the profitability ratio might be biased due to the volatility in net income.
Regarding the third hypothesis, no significant relationship is found between a bank’s level of risk and
risk disclosure. Therefore, it does not appear that the riskier banks are seeking to give the
marketplace confidence in their ability to manage risk through the disclosure of greater amounts of
risk information. Banks may not want to draw attention to their ‘riskiness’ and therefore may be
reluctant to voluntary disclose significant amounts of risk information. By contrast, banks with lower
levels of risk, perhaps because of their superior risk management abilities, may wish to signal this
through improved risk disclosure (Linsley and Shrives, 2006, p. 391). Linsley et al. (2006, p. 279)
suggest that it may be that the banks wish to keep discussions concerning their risk levels and their
risk management capabilities out of the public domain. This desire for privacy may be related to the
issue of proprietary costs. There is no empirical support for hypothesis 3. This confirms findings of
Linsley and Shrives (2005b), who used five proxies to capture the level of company risk but did not
found any of them significantly related to the extent of risk disclosure. Similar non-significant results
were found by Linsley et al. (2006), Lajili and Zeghal (2005) and Amran et al. (2009).
The fourth hypothesis (H4) emphasized that the extent of risk disclosure is greater for banks with
multiple listing statuses. The theoretical construct (see 5.4.4) seems very solid and is supported by
two earlier studies (Abraham and Cox, 2007 and Haniffa and Cooke, 2005). This study however shows
no significant coefficient on multiple listing statuses related to risk disclosure and therefore no
empirical support is found for the fourth hypothesis. On the other hand, the direction of the
relationship is positive, pointing towards a positive relationship that confirms the theoretical
construct. The relationship between credit ratings and risk disclosure is for the first time investigated
in risk disclosure research. It was argued that banks with higher credit ratings release more risk
disclosure than banks with lower credit ratings. However, the coefficient on credit ratings is negative
and not found to be significant. Therefore, the fifth hypothesis (H5) is not empirically supported.
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Regarding the sixth hypothesis about organizational structure, it has been hypothesized that a two-
tier structure leads to stronger corporate governance, and hence to more risk disclosure. However,
the coefficient is found to be not significant, meaning that there is no empirical evidence to support
this hypothesis. In contrast, it confirms the BCBS notion (1999) that there are no universally correct
answers to corporate governance structures, as these structures vary in different countries.
For the seventh hypothesis, the proportion of non-executive directors divided by the number of total
directors is used. According to Abraham and Cox (2007, p. 231) non-executives in the board give
balance in the organization and a board with non-executive directors in greater numbers is in a
stronger position to fulfill shareholder preferences for accountability and transparency. Testing the
variable however leads to no significant relationship.
6.4.4 Conclusion
Although the outcomes show that the model is powerful in explaining the variation in the extent risk
of disclosure, a detailed analysis of the independent variables show that only size is significant.
Regression analysis using ranked data leads to the same results.
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7 Conclusion
7.1 Introduction
This chapter presents the main conclusions from this study and furthermore gives attention to its
limitations and provides recommendations for future research.
7.2 Research conclusion
Never before has the importance of transparency and the role of risk disclosure been highlighted as
today. The recent credit crisis has emphasized the need for transparent and open disclosure of
financial information to all relevant market parties. When the risk management of an institution is
adequate, it is possible to obtain confidence in the markets by credible risk disclosure. On the other
hand, if the quality of risk management is poor, then it is likely that the risk disclosure is insufficient.
This study aimed to give insight in the risk disclosure practices and its determinants in the European
banking sector in 2007. The following research question has been formulated (chapter 1):
In which way do European banks disclose risks in the annual reports of 2007 and which firm-specific
characteristics influence the extent of risk disclosure?
Before the empirical research, first the institutional framework and theoretical framework related to
risk disclosure were described. Moreover, a literature review of risk disclosure has been provided
and discussed. The first part of the empirical research consisted of analyzing 40 annual bank reports
of 2007 by means of content analysis. Risk disclosure score was measured by the number of
sentences containing risk information. Furthermore, different attributes of the risk information were
taken into account: qualitative/quantitative, future/past and good/neutral/bad. The content analysis
showed how European banks disclosed risk in their annual reports.
This study shows the highest average of risk disclosure per annual report, compared to earlier studies
measuring the risk disclosure score in sentences. This indicates that banks are disclosing more risk
information in the annual report than a few year earlier. Analyzing the different risk categories shows
that credit and market risk are the most developed risk disclosure areas. This is in line with
expectations, as IFRS 7 and Basel II were introduced in 2007, supporting the notion that regulatory
requirements drive risk disclosure to a large degree. The examination of the characteristics of the risk
disclosures revealed that it can be questioned whether the increase in disclosure has led to more
useful disclosure. The majority of the risk disclosures is still qualitative, strong biased towards the
72
past and of neutral nature. Relatively little quantitative and future risk information is disclosed,
supporting the view that directors are not willing to disclose proprietary information due to its
sensitivity towards competitors or its high level of unreliability, increasing chances of possible
litigation. Directors could feel that they will be required to justify their estimates, when they disclose
future information which is inherently unreliable.
The second part of the empirical study tests for relationships between the gathered risk disclosure
score and potential explanatory firm characteristics. These include variables such as company size,
profitability, risk level, multiple listing statuses, credit rating and corporate governance
characteristics. The technique used is regression analysis (using both OLS and Rank Regression).
Although the outcomes show that the model is powerful in explaining the variation in the extent risk
of disclosure, a detailed analysis of the independent variables show that only the independent
variable size is significant. The significance of the size variable confirms theoretical constructs from
the stakeholder theory and findings of previous literature. As the bank grows bigger, it will have a
larger pool of stakeholders who would be interested to know the affairs of the company. Some
variables, found significant in earlier studies did not show significance in this study. The predicted
relationship between profitability and risk disclosure was not confirmed, but the positive coefficient
is consistent with the hypothesis. Moreover, leverage as a proxy of level of risk is not found
significant too. This supports the view of Linsley and Shrives (2006, p. 279) who suggest that directors
wish to keep discussions concerning their risk levels and their risk management capabilities out of
the public domain. This desire for privacy can be related to the subject of proprietary costs.
Additionally, the credit crunch might have had a major impact upon the profitability and leverage
ratios, and in that way possibly biased the results. The multiple listing and credit rating variables are
not found to be significant either and therefore seems not relevant for explaining risk disclosure.
Finally, this study takes two corporate governance variables into account. However, none of them
are found significant, confirming findings of Michiels et al. (2009) but contrasting with results of
Abraham and Cox (2007).
7.3 Limitations
An important limitation in this study lies in its method to analyze the annual report. Subjectivity of
content analysis cannot be fully eliminated because of the use of only one coder. However, chapter
five showed that several decisions were made to overcome major limitations of this method and to
increase the reliability of the coding process. Another limitation results from the fact that content
analysis only measures the extent of risk disclosure and not quality. Although the study strictly
considered focuses upon the extent of risk disclosure, the implicit underlying construct of interest is
73
generally the ‘quality’ of disclosure (as stated by Beattie et al., 2004, p. 4). Therefore, to analyze risk
disclosure more in-depth, characteristics of risk disclosure were examined. The study showed that
the qualification of past/future information was inadequate, as it might be argued that risk
information about current risk management practices cannot be considered as past nor future
information. Further research should distinguish another category next to past and future
information, namely “non-time-specific”. Finally, a limitation is found in sample size. Due to the
massive and time-consuming work of the content analysis method, only 40 cases (one annual report
of 40 European public listed banks) were analyzed.
7.4 Recommendations for future research
Since risk disclosure literature is scarce, further research into risk reporting would be beneficial. Risk
disclosure research over a couple of years could reveal more insight into patterns and practices of
risk disclosure by companies. Moreover, advanced techniques should be developed and used in
measuring quantity and quality of risk disclosure. Beattie et al. (2004) already introduced computer-
aided coding, to be able to analyze larger samples in an easy and reliable way. Another topic of
research that would enhance the understanding and effect of risk disclosure is to investigate in what
manner risk information would be of greatest use to annual report readers. These studies would be
beneficial and helpful to regulators to design and improve risk disclosure legislation.
74
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Appendix A
Dobler (2008, p. 188)
80
Appendix B
Basel II - Summary disclosure requirements
Disclosure area Nature of disclosures in summary
Capital disclosuresCapital structure Main features of capital instruments
Amounts of tier 1, 2 and 3 capitalCapital requirements
Capital adequacy
Risk exposure and assessment disclosuresCredit risk General disclosure of risk management objectives and policies
for each separate risk area including:Strategies and processesStructure and organization of the relevant risk mgt functionsScope and nature of risk reporting and measurement systemsPolicies for hedging and mitigating risks
Specific disclosures for each separate risk area as prescribed
Market riskOperational riskEquitiesInterest rate risk
81
Appendix C
Sample selection
BANK NAME COUNTRY TOTAL ASSETS (USD, in millions, 2007)
BKS Bank AUSTRIA 5.752KBC Group BELGIUM 523.476First Investment Bank BULGARIA 3.156Bank of Cyprus Group CYPRUS 46.759Marfin Popular Bank CYPRUS 44.542Komercni Banka CZECH REPUBLIC 36.609Spar Nord Bank DENMARK 12.491Amagerbanken DENMARK 6.128Vestjysk Bank DENMARK 3.648BNP Paribas FRANCE 2.494.412Société Générale FRANCE 1.577.745Crédit Agricole FRANCE 2.081.883Commerzbank GERMANY 907.514Deutsche Bank GERMANY 2.833.804Comdirect Bank GERMANY 12.120Bank of Attica GREECE 5.747General Bank of Greece GREECE 6.381EFG Eurobank Ergasias GREECE 100.676Allied Irish Banks IRELAND 261.831Banca Ifis ITALY 1.877Banca Generali ITALY 6.199Banca Popolare di Milano ITALY 64.223Credito Valtellinese Soc Coop ITALY 25.362Banco Desio SpA ITALY 11.893Banca popolare dell'Etruria e del Lazio ITALY 12.587Siauliu Bankas LITHUANIA 875FIMBank Plc MALTA 571Van Lanschot NETHERLANDS 31.972ING Groep NETHERLANDS 1.932.151Bank Zachodni WBK POLAND 16.969Banco BPI PORTUGAL 59.688Tatra Banka SLOVAKIA 11.032OTP Banka Slovensko SLOVAKIA 2.167Probanka d.d. Maribor SLOVENIA 1.613Bankinter SPAIN 73.088Banco Bilbao Vizcaya Argentaria SPAIN 502.204Svenska Handelsbanken SWEDEN 289.915Barclays UNITED KINGDOM 2.459.149Schroders UNITED KINGDOM 13.778HSBC Holdings UNITED KINGDOM 2.354.266
82
Appendix D
Risk classification model
Risk category Subcategory1 Market risk interest rate risk
foreign exchange riskcommodity riskequity price risk
financial risks2 Credit risk counterparty risk
3 Liquidity risk liquidity risk
4 Operational risk failing of internal processesfailing of people; human error riskfailing of systems; IT riskinformation access and availability riskfraud riskinternal control weaknessescustomer satisfactionproduct and service failure risk
5 Business risk strategic riskcompetition riskreputation risk environmental risksystemic risk
6 Legal risk lawsuits, litigationchange in political environmentchange in legislationchange in tax law
7.
Capital structure and adequacy risk off balance structures
risk based ratiosrisk exposures of on- and off balance assets
8.
Risk management and policies risk management
actions and policies
83
* This model shows the most relevant risk areas for the banking industry and is based upon theory
and the risk classification models of Linsley et al. (2006), KPMG (2008), Amran et al. (2009) and
Michiels et al. (2009).
84
Appendix E
Coding grid
Market risk
Credit risk
Liqui-dity risk
Oper-ational risk
Business risk
Legal risk
Capital structure, adequacy risk
Risk management and policies
Sentence characteristics 1 2 3 4 5 6 7 8Quantitative Good Future AQuantitative Bad Future BQuantitative Neutral Future CQualitative Good Future DQualitative Bad Future EQualitative Neutral Future FQuantitative Good Past GQuantitative Bad Past HQuantitative Neutral Past IQualitative Good Past JQualitative Bad Past KQualitative Neutral Past L
85
Appendix F
Based upon Linsley et al. (2006) and Amran et al. (2009)
Decision rules for coding risk disclosures
(1) To identify risk disclosures, a broad definition of risk is adopted as explained below.
(2) Sentences are to be coded as risk disclosures if the reader is informed of any opportunity or
prospect, or of any hazard, danger, harm, threat or exposure, that has already impacted
upon the company, or may impact upon the company in the future or of the management of
any such opportunity, prospect, hazard, harm, threat or exposure.
(3) The risk definition just stated shall be interpreted such that “good” or “bad” “risk” and
uncertainties will be deemed to be contained within the definition.
(4) The type of risk disclosure shall be classified according to appendix E.
(5) If a sentence has more than one possible classification, the information will be classified into
the category that is most emphasized within the sentences.
(6) Tables (quantitative and qualitative) that provide risk information should be interpreted as
one line equals one sentence and classified accordingly.
(7) Any disclosure that is repeated shall be recorded as a risk disclosure sentence only when new
information is revealed or discussed.
(8) If a disclosure is too vague in its reference to risk, then it shall not be recorded as risk
disclosure.
86
Appendix G
Examples of risk disclosure in the sampled banks’ annual reports:
Commerzbank, Germany, p. 99: “Commerzbank has been able to respond quickly and strategically to
changing market situations using the liquidity risk measurement and control method that was
developed and established internally years ago – the available net liquidity (ANL) concept.”
Coded as J3 in the coding grid: liquidity risk, good news, qualitative and referring to the past.
FIMBank, Malta, p. 51: “As the Group carries out activities with counter-parties in emerging markets,
there are certain risk factors which are particular to such activities and which require careful
consideration by prospective investors since they are not usually associated with activities in more
developed markets.”
Coded as F2 in the coding grid. Counterparty risk is subcategorized under credit risk, it is neutral
news and refers to current practices that are in place and will be, and as such characterized as future
news.
Barclays, United Kingdom, p. 81: “Barclays Capital’s market risk exposure, as measured by average
total Daily Value at Risk (DVaR), increased to an average of £42m in 2007.”
Coded as H1 in the coding grid. Market risk, quantitative, refers to the past and can be interpreted as
bad news, taking the context into consideration.
ING, Netherlands, p. 83: “ING Bank has a framework of risk management policies, procedures and
standards in place to create consistency throughout the organization, and to define minimum
requirements that are binding on all business units.”
Coded as F8 in the coding grid. Disclosure about risk management policies, currently in place, neutral
and qualitative of nature.
Svenska Handelsbanken, Sweden, p. 54: “The economic capital model which is a component in this, is
designed to ensure that the Group has sufficient capital in relation to all its risks at any point in time.”
Coded as F7 in the coding grid. Capital structure and adequacy risk, qualitative, and future
information.
87
Appendix H
BANK NAME RISK DISCLOSURE SCORESvenska Handelsbanken 321Spar Nord Bank 163Amagerbanken 158Vestjysk Bank 59BNP Paribas 314Société Générale 288Crédit Agricole 518Commerzbank 461Deutsche Bank 506Comdirect Bank 158Banca Ifis 175Banca Generali 155Bank of Attica SA 40General Bank of Greece 104Allied Irish Banks 393EFG Eurobank Ergasias 122Banca Popolare di Milano 279Van Lanschot 239ING Groep 701Bankinter 211Banco Bilbao Vizcaya Argentaria 350Barclays 753Schroders 152Bank of Cyprus Group 182Marfin Popular Bank 168Komercni Banka 243Bank Zachodni 248Banco BPI 285HSBC Holdings 735Tatra Banka 142OTP Banka Slovensko 70Siauliu Bankas 117Probanka d.d. Maribor 189Credito Valtellinese 225FIMBank 112Banco Desio 247Banca popolare dell'Etruria e del Lazio 170BKS Bank AG 167KBC Group 300First Investment Bank 109
Appendix I
88
Output SPSS – OLS Regression
Model Summaryb
Model R R Square
Adjusted R
Square
Std. Error of the
Estimate Durbin-Watson
1 ,849a ,720 ,669 ,37605 1,684
a. Predictors: (Constant), TIER, LNLEV, ML, CR_TF, LNPROF, LNSIZE
b. Dependent Variable: LNRDSCORE
Coefficientsa
Model
Unstandardized
Coefficients
Standardized
Coefficients
t Sig.
Collinearity Statistics
B Std. Error Beta Tolerance VIF
1 (Constant) 3,252 ,931 3,493 ,001
LNSIZE ,205 ,054 ,786 3,784 ,001 ,197 5,086
LNPROF ,134 ,170 ,136 ,790 ,435 ,284 3,517
LNLEV -,007 ,249 -,007 -,029 ,977 ,163 6,152
ML ,133 ,200 ,089 ,665 ,511 ,471 2,125
CR_TF -,064 ,101 -,093 -,631 ,532 ,388 2,575
TIER ,170 ,137 ,126 1,241 ,223 ,825 1,213
a. Dependent Variable: LNRDSCORE
NONEXEC -1,130 ,805 -,204 -1,404 ,176 ,738 1,355
89
Output SPSS – Rank Regression
Model Summaryb
Model R R Square
Adjusted R
Square
Std. Error of the
Estimate Durbin-Watson
1 ,857a ,734 ,686 6,551275 1,857
a. Predictors: (Constant), TIER, Rank of LEV_ED, ML, CR_TF, Rank of ROA, Rank of
TA_USD_MIL
b. Dependent Variable: Rank of RDSCORE
Coefficientsa
Model
Unstandardized
Coefficients
Standardized
Coefficients
t Sig.
Collinearity Statistics
B Std. Error Beta Tolerance VIF
1 (Constant) 3,348 8,354 ,401 ,691
Rank of TA_USD_MIL ,769 ,179 ,769 4,284 ,000 ,250 3,997
Rank of ROA ,071 ,132 ,071 ,537 ,595 ,461 2,171
Rank of LEV_ED -,034 ,187 -,034 -,183 ,856 ,230 4,350
ML 3,353 3,326 ,126 1,008 ,321 ,517 1,934
CR_TF -,263 1,788 -,022 -,147 ,884 ,374 2,675
TIER 1,738 2,355 ,072 ,738 ,466 ,850 1,176
a. Dependent Variable: Rank of RDSCORE
Rank of NONEXEC -,171 ,220 -,110 -,779 ,446 ,723 1,383
90
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