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   Rethinking the quality of risk managemen...
     
     I. Introduction
     
















 

Rethinking the quality of risk management disclosure practices

I. Introduction

I.1 The importance of a standard evaluation framework for risk management disclosure

The key economic function of shareholders is to allocate their investment dollars to firms with the best risk-adjusted investment opportunities. Through their pursuit of self-interest society benefits from the consequent higher growth of the economy. Given diffused ownership, to function effectively the shareholders must be able to assess not only the firm's risks, but also the firm's risk management process, i.e. the policies, procedures and models used by the risk managers. Despite the crucial role of the quality of risk management disclosure, recent examples provide evidence of delayed and incomplete disclosure of risk information to the firm's investors, e.g. Barings, several Japanese banks and Long Term Capital.

Risk disclosure failures can occur at the macroeconomic level as well, e.g. the crises in Asia, Russia and Brazil. These examples demonstrate the growing vulnerability of large collective investments, individual countries and entire economic regions to a sudden lack of confidence of investors. For both firms and macro-economies, these disruptions were, in part, exacerbated by the delayed disclosure of debt burdens, government deficits, trading losses and leverage exposures. These financial crises took investors by surprise and enhanced their scepticism of the ability of market institutions to self-regulate their risk disclosure policies adequately. After the LTC collapse, some regulatory authorities and politicians promoted the idea that the risk disclosure practices of the hedge fund industry should be regulated. If the banking industry wishes to promote self-regulation then it must significantly improve the quality of its risk disclosure rules.

I.2 Barriers to a standard evaluation framework for risk management disclosure

The financial services industry, auditing firms and supervisory authorities agree that a standard evaluation framework for risk management disclosure will increase the confidence of market participants in the risk management practices of banks, insurance companies and conglomerates. However, there are three significant barriers to the definition and enforcement of a standard evaluation framework. The first barrier is the rapid pace of innovation in the risk management area. Five years ago, little was understood about credit risk management. Yet today, many financial firms use internally developed credit risk models to manage the counter-party risk exposures of their trading books and loan portfolios. Their current preoccupation is the proper definition and quantification of operational and liquidity risks and the integration of the risk management system within the firm.

The second barrier is the evolution of the structural architecture of the financial services industry: the entry of new players (e.g. insurance companies, hedge funds, internet banks) and the disappearance of banks into enormous financial conglomerates. Because firms are likely to be regulated by different supervisory authorities and thus to be subject to distinct accounting rules, standardisation of disclosure regulations remains a distant hope, despite the recent efforts of the BIS and the G-7 to promote co-ordination and information sharing across regulatory entities. (For the BIS see "Supervision of Financial Conglomerates", February 1998 and for the G-7 see "Report on the Supervision of Global Financial Institutions", May 1998.) Globalisation of financial markets may encourage standardisation, however national and cultural barriers weaken its enforcement.

The third and most significant barrier to the development of meaningful, harmonious and enforceable standard evaluation framework is the poor understanding of its core concept: economic valuation. Financial economists and accountants have spent decades developing tools to assess the economic value of financial and real assets. Yet difficulties persist in their application. Marking-to-market valuation is certainly more appealing, under normal market conditions, than book valuation. However its extension to on- and off-balance sheet assets pose a multitude of problems: 1) the lack of liquidity of the asset or the underlying instrument, 2) informational asymmetries and 3) poorly quantifiable risk factors, such as legal, political, credit and operational. In disrupted and below investment grade markets, it is not clear when market prices can be equated with the economic value of the assets.

 

I.3 The scope of the proposed standard evaluation framework for risk management disclosure

The purpose of the present study is to propose a standard framework for evaluating the risk management disclosure quality based on qualitative and quantitative information. We limit our attention to disclosure in annual reports, to market and credit risks and to financial firms, as explained below. The goal of the standard evaluation framework is to allow financial analysts, shareholders, creditors, clients and other interested parties to rely on minimal standards of quality and consistency in the risk management policies of financial firms. The standard should enable market participants to form an objective opinion about risk management practices, across firms, across market segments and over time.

We choose the annual report as the only data source for our standard evaluation framework of the quality of the risk management disclosure for four important reasons. First, for many market participants the annual report remains the primary publicly available source of information, along with analyses by the major rating agencies. Second, the annual report is widely disseminated, thus it represents the firm's disclosure to all potential market participants. Third, it is reasonably standardised within and across countries. Fourth, its publication and accuracy are legally mandated in all countries. Though a financial firm may be reluctant to quickly reveal its latest risk management system failure to the analysts, its disclosure would be legally mandated in the annual report. While the annual report is too infrequent to assess the timeliness of disclosure, a time series of annual reports can be used to assess the evolution of the quality of a firm's disclosure practices. For the above reasons, annual reports are the only reasonable choice as the data for an evaluation of the quantity and quality of the disclosure practices of a firm.

 

In our standard evaluation framework for risk management disclosure, we deliberately limit the risk categories to market and credit risks. This choice is motivated primarily by the need to rely on measurable, comparable and objective criteria when judging risk management disclosure practices across financial institutions. At the current stage of development in risk management, these are the only risks for which measures are well defined. In contrast to operational risks, for instance, these risks are measurable using market and credit risk management models. Firms generally issue sufficient qualitative and quantitative information about these risks to permit meaningful comparisons. Indeed, a firmly grounded evaluation of the quality of risk management disclosure policies needs the definition of a common benchmark. At the current time this is not feasible for other categories of risks. Indeed, annual reports seldom contain more than simple definitions or descriptive data regarding aggregate exposures to other sources of risks, such as liquidity, accounting, legal or operational risks. A future study might draw on the framework in this study and on the evolution of knowledge in the field in order to incorporate these other important sources of risk into a more complete appraisal of the quality of risk management disclosure practices.

For comparability reasons we limit our standard evaluation framework to banks and other regulated securities firms that are active in the international capital markets. Ideally, we should be including all firms in the financial services industry irrespective of whether or not they are structured as banks, investment and brokerage houses, insurance companies or financial conglomerates. However, there is still a wide discrepancy in the regulatory and accounting standards across firms. This leaves us far from a consensus view of what the risk management minimum disclosure requirements should be across various legal forms and economic sectors. Certainly, there is a growing trend (see the joint report on "Supervision of Financial Conglomerates" issued in February 1998 by IOSCO and the BIS) towards harmonising regulatory capital requirements and thus enforcing current risk management practices at the level of insurance companies and financial conglomerates. Yet, we still lack the concrete steps that would translate this goal into more than a few pragmatic rules for the presentation of the annual reports of financial conglomerates. Further, only banks and other regulated securities firms that are active in the international capital markets have sufficient risk management information to satisfy the requirements of the standard evaluation framework presented here. Broadly speaking, these are the 67 banks and 12 securities firms from the G-10 whose derivative trading disclosure policies were analysed in the joint IOSCO and BIS "Survey of Disclosure about Trading and Derivatives Activities of Banks and Securities", in November 1996.

I.4 BIS and IOSCO proposed framework

Enhanced disclosure currently preoccupies national and supranational regulatory and advisory bodies. Following a number of recent joint studies by the BIS and IOSCO, they have proposed a framework for disclosure to supervisory authorities. One study, issued in September 1998 and titled "Objectives and Principles of Securities Regulation", sets the need for disclosure at the core of regulatory objectives when supervising issuers, collective investment schemes, secondary markets and market intermediaries. A second study, also issued in September 1998 and titled "Enhancing Bank Transparency", urges supervisory bodies to actively encourage disclosure of timely and reliable information as a tool to enhance market discipline. In particular, the BIS recommends that banks enhance the quality of their disclosure when communicating their financial performance, financial positions, risk management practices, risk exposures, accounting policies, general management strategies and corporate governance strategies. However both studies are presented as general guidelines, aimed at repositioning the role of transparency for supervision of financial institutions, without defining how qualitative minimal standards for disclosure should be designed and measured.

Some specific attempts by the BIS and IOSCO (see 1997 and 1998 "Survey of disclosures about trading and derivatives activities of banks and securities firms") present a statistical picture of progress toward disclosure goals. They report the number or % firms which disclose a given figure (say a VAR figure for their trading books) in the annual report and the increase each year in the firms that disclose a specific item. However, these surveys do not judge the quality of the specific information disclosed, for instance whether the firm provides the confidence interval and the holding period over which it computes its VAR, or whether it comments meaningfully on the model being used to compute the individual and aggregate VAR figures. Finally, these surveys only focus on the statistical information related to a firm's derivatives and trading activities and thus ignore the quality of disclosure of non-trading activities, in particular loan portfolios.

In this respect the more recent joint BIS and IOSCO document, titled "Framework for supervisory information about derivatives and trading activities" and released in September 1998, represents a breakthrough. It sets detailed minimal quantitative, as well as qualitative, guidelines for the presentation of the risk management practices that supervisors should expect from regulated firms. Furthermore, this framework proposes that the information to be collected by regulators be harmonised not only for derivatives but for cash instrument trading activities as well.

I.5 Description of the standard evaluation framework for risk management disclosure

The present study thus pursues a similar objective to this recent BIS and IOSCO document, but with respect to the disclosure of market and credit risks to all market participants rather than just to supervisory authorities. For that purpose, it proposes a concrete and practical framework for evaluating the quality of risk management disclosure with respect to the information released in the annual reports of financial firms. The framework has three distinctive features. First, it proposes that the disclosed risk management information be comprehensive and offer a maximum level of comparability across firm practices, irrespective of differing legal systems, domicile countries and economic activities. Hence, the disclosure should focus on the risk management of the trading as well as the non-trading activities of financial firms. Second, the framework proposes five general propositions for evaluating the quality of the risk management disclosure of a firm. These propositions start by defining objectives and end with a standard evaluation framework for risk management disclosure contained in the annual report. Third, the framework partitions the risk management disclosure along the main economic functions of the firm, in other words along their trading and non-trading activities.

Three reasons motivate this partitioning along the main economic functions. First, the assets in the trading book are generally more actively traded and their marking-to-market is, under normal market conditions, less problematic than for assets in the non-trading book. Second, the time horizon pertaining to both trading and non-trading activities is different and thus requires different economic valuation techniques. For the trading book assets, the best alternative, market value, is easily available. On the other hand, for assets in the non-trading book, strategic or liquidity considerations may often lead firms to place more weight on techniques such as synergy value, the liquidation value and the ongoing-concern value. For instance, a traded credit derivative may be easier to price than a long-term loan guarantee issued by a counter-party or by a hedge fund investment. In addition, most assets in the non-trading book are less liquid, which limits the appropriateness of marking-to-market or even marking-to-model. Third, regulatory and accounting practices across countries and institutions are less harmonious for on- and off-balance sheet valuation principles. Traded assets are generally subject to more broadly accepted marking-to-market or marking-to-model valuation methods, which raises a new source of risk, model risk. Model risk is most significant for the pricing of complex instruments such as exotic options or structured products, chiefly found in the trading book.

We also believe that a functional evaluation of the quality of risk management disclosure parallels the functional perspective frequently taken in the financial services industry and more recently its regulation. Economic functions are slow to change while structures (for example banks, insurance companies and exchanges) and products can evolve quickly and become extinct. Thus the functional approach offers the advantage of flexibility, homogeneity and adaptability to the particular innovation path of the financial services industry. The functional approach to disclosure also enables identification and attribution of responsibilities and assessment of management performance across the various segments of the financial services industry. Indeed, a financial firm that has mostly non-trading activities should not be directly compared or penalised relative to another firm that relies heavily on the trading book to generate income (and thus has an easier task of disclosure).

The present study is organised as follows. In section II, we briefly discuss why financial disclosure is important from an academic perspective based on some major theoretical and empirical contributions in the finance literature. In section III, the five general risk management disclosure propositions are stated. In section IV, these propositions are used to develop a standard evaluation framework for the quality of the disclosure of market and credit risk management practices for trading and non-trading activities of financial firms.

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