Banks’ disclosure and financial stability

Rhiannon Sowerbutts, Ilknur Zer, Peter Zimmerman

Inadequate disclosure by banks increased funding costs and contributed to the recent crisis. This column presents quantitative indices to measure progress of disclosure between banks and over time. Internationally, disclosure has improved since 2000. However, more information alone is not sufficient to solve the problem. More needs to be done to ensure that the information provided is useful to investors, and that investors are incentivised to use this information. The ongoing reform agenda aims to address this.

Investors in banks need information about the risks that they are exposed to in order to be able to assess and price those risks properly. However, during the recent crisis, investors found that they did not have enough information to assess these risks, which led to a dramatic increase in funding costs, intensifying the crisis (Gorton 2008). Increased disclosure can help to alleviate the problem of asymmetric information between banks – who have more information about their own financial resilience – and investors, who may have less information.

During good times, too, disclosure enables market discipline, allowing debt investors to ensure that banks do not take on too much risk. If banks are not properly disciplined, then bank managers will have access to more information than outsiders, making the cost of issuing equity more expensive (Myers and Majluf 1984). That can mean that banks have incentives to become more leveraged — and thus more fragile — than is optimal.

Crockett (2001) proposes four requisites to ensure that the market discipline mechanism functions effectively (see Figure 1).

Figure 1. Requisites for investors to exert effective market discipline

Source: Crockett (2001).

We examine each of these areas in turn to assess progress made since the crisis and what remains to be done.

Availability of information

The Bank of England, in its December 2009 Financial Stability Report, discussed banks’ disclosure practices and said that “better information would 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 can identify five areas where significant improvements in reporting information would be desirable:

funding risk;

group structure;

valuation methods;

intra-annual information; and

financial interconnections.1

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

We introduce quantitative indices to measure progress on disclosure in the five areas mentioned above and apply it to a sample of 50 major banks from around the world. These indices are focused only on information that is expected to be relevant to debt investors and to financial stability. The indices are composed 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 each indicator, depending on whether the necessary information was disclosed in its annual public report. We collect these scores for a sample of 50 of the largest banks in the world for even-numbered years between 2000 and 2012 inclusive.

We only look at information which is currently over and above that required by international standards. In order to ensure a focus on the main source of information for investors, only data from annual reports — rather than separate regulatory reporting or other sources — have been used. For more detail on the construction of these indices, see Sowerbutts et al. (2013).

On a global level, there has been an improvement in disclosures over time. Figures 2a, 2b and 2c show the average disclosure scores for the funding risk, valuation, and financial interconnections categories over the period 2000–12. Each line shows the average for the group of banks in that jurisdiction. There is an upward trend in all three categories. Most marked is the improvement in information about valuation methodologies from 2008. The charts suggest that UK banks were, relative to their international peers, fairly poor at disclosing information prior to the crisis, but have improved considerably since then.

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 could be a result of action by national authorities, investor demand, or a combination of the two. For example, the increase in the financial interconnections scores is mainly driven by better disclosure of sponsorship of off balance sheet entities. Since this was a key driver of bank distress in 2007 and 2008, it may be that investors have begun to demand better disclosure of this risk as a result. Alternatively, this change may be driven by anticipation of post-crisis improvements to accounting and regulatory rules in this area.

As well as variation in disclosure across time, we also observe variation in the cross-section. Figure 3 shows a wide variation in the distribution of banks’ 2012 scores in each of the five categories. This could occur because of 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).

In addition, disclosures may be ‘path-dependent’ in the sense that investors and counterparties expect reported information to be provided on an ongoing basis once it has been instigated. Ceasing to disclose an item could increase uncertainty for investors or stigmatise the bank. This would suggest an upward trend in the ‘path’ for bank disclosure, consistent with the increase that can be observed in the indices.

Other requisites for effective market discipline

As suggested by Crockett’s four requisites, while greater disclosure is a necessary ingredient for effective market discipline, it may not be sufficient. Other factors need to be present to ensure that there are desired benefits for financial stability.

As well as having information available, investors must have the ability to process this information. Large amounts of data that are not key to understanding the risks banks are taking may make it more difficult for investors to extract the key information.

In the UK, banks’ annual reports have increased considerably in length since 2000. At over 300 pages, their average length is over three times that for UK companies as a whole (Deloitte 2011). This could be driven by various factors, such as increased regulatory demands or business complexity. It is difficult to judge whether investors find this additional information useful. While it could be a natural consequence of banks’ business models becoming more complex, it does nonetheless suggest that it may have become more difficult for investors to read and analyse a typical bank’s annual report over time.

The 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 means that a debt investor may be more concerned with the solvency of the government than the bank. Analysis of credit ratings and equity prices suggests that this subsidy can be economically material (Noss and Sowerbutts 2012, Acharya, Anginer, and Warburton 2013).

Finally, for market discipline to be effective, investors need to be able to influence managers’ actions, either directly or indirectly. Typically, only equity holders have direct control rights. But relying on equity holders to discipline management may not be sufficient — debt and equity holders often have different and conflicting interests when it comes to the risk that a firm takes.

Policy developments and conclusion

A number of policy developments are likely to lead to further improvements in the requisites for market discipline. In the UK, the Bank of England’s Financial Policy Committee (FPC) — which works to protect and enhance the resilience of the financial system — has issued a number of recommendations relating to public disclosure. Internationally, the first progress report of the EDTF found that its recommendations are already beginning to make a positive impact 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 address the ‘too important to fail’ problem should increase incentives for investors to exercise market discipline. For example, effective and credible resolution regimes should reduce the perceived likelihood of government support, thus weakening the link between sovereigns and banks.

With hindsight it is relatively simple to identify areas of inadequate disclosure; the challenge is to future-proof disclosure in an innovative industry and where the incentive structure encourages the build-up of new types of risks which may not be covered by existing rules and guidance. Policymakers therefore need to build disclosure frameworks that keep up to speed with evolving business models and emerging risks. And policy developments should not only aim to continue to improve disclosure, but also to ensure that investors have stronger abilities and incentives to exercise market discipline. This should help reduce excessive risk-taking by banks, leading to positive outcomes for financial stability.

References

Acharya, V V, Anginer, D, and Warburton, A (2013), “The End 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 risk 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 do not 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.

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