The Value Relevance of Risk Disclosure: An Analysis of the Banking Sector

Posted by BEGOÑA GINER - Feb 28, 2020

By Begoña Giner, Alessandra Allini and Annamaria Zampella

In this study, we test whether financial risk disclosures required by IFRS 7 and Pillar 3 are value relevant for investors in the European banking sector. The motivation of this research relies upon the concerns expressed by relevant institutions (i.e. the International Monetary Fund). They alerted on the increasingly use of complex instruments without providing relevant and reliable information, which could undermine the stability of financial markets. Indeed, the financial collapse of European banks that have led either to bankruptcy or significant market losses (e.g. Allied Irish Bank), confirms the dangers related to inappropriate risk disclosures. Consequently, it is not surprising that there is a general call for more transparency to monitor the risks associated with the use of financial instruments. Hopefully, new disclosure requirements under both accounting and prudential standards, this is IFRS 7 and Pillar 3 Basel II, should support investors in adequately assigning risk levels in their economic decisions. Even though the co-existence of both standards creates a somewhat confusing scenario, both aim to increase transparency that is likely to improve market stability.

 A sample composed by banks listed in the stock markets of the five main European countries by gross domestic product (GDP), over an 8-year period, from 2007–2014, has been used to perform a value relevance study. In brief the paper establishes a main research hypothesis: Are bank financial risk disclosure requirements relevant for market investors?

Consistent with prior value-relevance literature, our study considers the major accounting items (i.e. earnings and book value of equity), but also includes some controls (in particular a risk measure based on the accounting data), and adds information indexes based on the specific requirements of IFRS 7, which are similar to those established by Pillar 3. Manual content analysis is used to attach a score to each observation and compute the risk disclosure indexes (quantitative and qualitative information; as well as credit, liquidity and market risk).

Final results confirm a significant and positive association between bank financial risk disclosure and market prices, implying that this information is value relevant. Furthermore, it is important to highlight that only when disclosure is included in the model, risk measures obtained from the main financial statements become relevant. In other words, risk disclosure enhances the value relevance of traditional risk measures. Besides, our analysis tries to control for the overlapping of FRS 7 and Pillar 3, and considers the strength of the banking authority compared with that of the market. Our results suggest that investors pay attention to the strength of the bank authority when using bank risk disclosures.

This research provides several contributions. First, it extends existing literature about the relevance of bank financial risk disclosure. Prior literature assumes that the requirements under IFRS 7 and Pillar 3 should contribute to bank transparency, but even after their implementation some authors still state that bank financial risk disclosure is a contentious issue. Second, this study could be beneficial for regulators and policy makers, since greater transparency is a significant contributor to the stability of the banking system. Besides, our results suggest that the value relevance of disclosure is influenced by the power of the banking regulator rather than that exercised by the market, which could be seen as a red flag for market regulators in their supervisory role. Lastly, this evidence may help the IASB in the development of its project on Disclosure. Nevertheless, we highlight that the disclosure indexes have been based on the specific information required by IFRS 7, hence it does not suggest that a disclosure standard is useful for the users, rather the detailed requirements that derive from the principle are useful.

Read our full paper here