Banks’ disclosure and financial stability

Option of information

THE LENDER of England, in its December 2009 Financial Stability Report, discussed banks’ disclosure practices and said that “better information could have constrained excessive risk-taking behaviour in the run-up to the crisis” (Bank of England 2009). And it suggested that UK banks were behind their international peers in this regard. From the Report, we are able to identify five areas where significant improvements in reporting information will be desirable:

  • funding risk;
  • group structure;
  • valuation methods;
  • intra-annual information; and
  • financial interconnections. 1

Internationally, and recently, these areas are also highlighted by the Enhanced Disclosure Task Force (EDTF 2012), an exclusive sector initiative which recommendations have already been endorsed by the Financial Stability Board.

We introduce quantitative indices to measure progress on disclosure in the five areas mentioned previously and apply it to an example of 50 major banks from all over the world. These indices are focused only on information that’s expected to be highly relevant to debt investors also to financial stability. The indices are comprised of fourteen indicators which measure disclosure in those five areas (Table 1).

Table 1 . The disclosure indices

Source: Sowerbutts et al. (2013).

A bank scores between 0 and 1 for every indicator, depending on if the necessary data was disclosed in its annual public report. We collect these scores for an example of 50 of the biggest banks on the planet for even-numbered years between 2000 and 2012 inclusive.

We only look at information which happens to be in addition to that required by international standards. To be able to ensure a concentrate on the main way to obtain information for investors, only data from annual reports – instead of separate regulatory reporting or other sources – have already been used. For greater detail on the construction of the indices, see Sowerbutts et al. (2013).

On a worldwide level, there’s been a noticable difference in disclosures as time passes. Figures 2a, 2b and 2c show the common disclosure scores for the funding risk, valuation, and financial interconnections categories over the time 2000-12. Each line shows the common for the band of banks for the reason that jurisdiction. There can be an upward trend in every three categories. Most marked may be the improvement in information regarding valuation methodologies from 2008. The charts claim that UK banks were, in accordance with their international peers, fairly poor at disclosing information before the crisis, but have improved considerably since that time.

Figure 2a . Funding risk category scores

Figure 2b . Valuation category scores

Figure 2c . Financial interconnections category scores

Source: Sowerbutts et al. (2013).

The post-2008 improvements is actually a consequence of action by national authorities, investor demand, or a combined mix of the two. For instance, the upsurge in the financial interconnections scores is principally driven by better disclosure of sponsorship of off balance sheet entities. Since this is an integral driver of bank distress in 2007 and 2008, it might be that investors have begun to demand better disclosure of the risk consequently. Alternatively, this change could be driven by anticipation of post-crisis improvements to accounting and regulatory rules in this area.

And also variation in disclosure across time, we also observe variation in the cross-section. Figure 3 shows a broad variation in the distribution of banks’ 2012 scores in each one of the five categories. This may occur due to different accounting and regulatory standards between countries, different investors’ preferences, or because differences in banks’ business models mean some information is more relevant than other.

Figure 3 . Frequency of 2012 category scores

Source: Sowerbutts et al. (2013).

Furthermore, disclosures could be ‘path-dependent’ in the sense that investors and counterparties expect reported information to be provided on a continuing basis once it’s been instigated. Ceasing to reveal something could increase uncertainty for investors or stigmatise the lender. This might suggest an upward trend in the ‘path’ for bank disclosure, in keeping with the increase which can be seen in the indices.

Other requisites for effective market discipline

As suggested by Crockett’s four requisites, while greater disclosure is a required ingredient for effective market discipline, it could not be sufficient. Other factors should be present to make sure that there are desired benefits for financial stability.

In addition to having information available, investors will need to have the opportunity to process this information. Huge amounts of data that aren’t key to understanding the risks banks are taking could make it more challenging for investors to extract the main element information.

In the united kingdom, banks’ annual reports have increased considerably long since 2000. At over 300 pages, their average length has ended 3 x that for UK companies all together (Deloitte 2011). This may be driven by various factors, such as for example increased regulatory demands or business complexity. It really is difficult to guage whether investors find this more information useful. While it is actually a natural consequence of banks’ business models becoming more technical, it does nonetheless claim that it may have grown to be more challenging for investors to learn and analyse an average bank’s annual report as time passes.

The current presence of a ‘too big to fail’ problem could reduce investors’ incentives to rein in undue risk-taking. Anticipation of government support for a failing bank implies that a debt investor could be more worried about the solvency of the federal government compared to the bank. Analysis of credit scores and equity prices shows that this subsidy could be economically material (Noss and Sowerbutts 2012, Acharya, Anginer, and Warburton 2013).

Finally, for market discipline to work, investors have to be in a position to influence managers’ actions, either directly or indirectly. Typically, only equity holders have direct control rights. But counting on equity holders to discipline management might not be sufficient – debt and equity holders frequently have different and conflicting interests with regards to the risk a firm takes.

Policy developments and conclusion

Numerous policy developments will probably result in further improvements in the requisites for market discipline. In the united kingdom, the lender of England’s Financial Policy Committee (FPC) – which works to safeguard and improve the resilience of the economic climate – has issued several recommendations associated with public disclosure. Internationally, the first progress report of the EDTF discovered that its recommendations already are starting to make a positive effect on the reporting practices of global banks. In June 2013, the FPC recommended that UK banks’ 2013 annual reports should comply fully with the EDTF recommendations (Bank of England 2013).

Measures to handle the ‘too vital that you fail’ problem should increase incentives for investors to exercise market discipline. For instance, effective and credible resolution regimes should decrease the perceived odds of government support, thus weakening the hyperlink between sovereigns and banks.
With hindsight it really is relatively simple to recognize regions of inadequate disclosure; the task is to future-proof disclosure within an innovative industry and where in fact the incentive structure encourages the build-up of new types of risks which might not be included in existing rules and guidance. Policymakers therefore have to build disclosure frameworks that continue to speed with evolving business models and emerging risks. And policy developments shouldn’t only aim to continue steadily to improve disclosure, but also to make sure that investors have stronger abilities and incentives to exercise market discipline. This will lessen excessive risk-taking by banks, resulting in positive outcomes for financial stability.

References

Acharya, V V, Anginer, D, and Warburton, A (2013), “THE FINISH of Market Discipline? Investor Expectations of Implicit State Guarantees”, working paper.

Bank of England (2009), Financial Stability Report, Issue No.26, December.

Bank of England (2013), Financial Stability Report, Issue No.33 June.

Crockett, A (2001), “Market discipline and financial stability”, Bank for International Settlements, 23-25 May, London.

Deloitte (2011), “Gems and jetsam: surveying annual reports”

Enhanced Disclosure Task Force (2012), “Enhancing the chance disclosures of banks”, 29 October.

Gorton, G B (2008), “The panic of 2007”, papers and proceedings for the Federal Reserve Bank of Kansas City, Jackson Hole Conference.

Myers, S C and Majluf, N S (1984), “Corporate financing and investment decisions when firms have information that investors don’t have”, Journal of Financial Economics, Vol. 13, No. 2, pages 187-221.

Noss, J and Sowerbutts, R (2012), “The implicit subsidy of banks”, Bank of England Financial Stability Paper No. 15

Sowerbutts, R, P Zimmerman and I Zer (2013), “Banks’ disclosure and financial stability”, Bank of England Quarterly Bulletin, Vol. 53, No. 4, pages 326-335.

1 The Report identified six areas, but we combine ‘frequency’ and ‘intra-period information’ right into a single category entitled ‘intra-annual information’.

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