Reporting standards: Investors demand enhanced disclosures

By:
Peter Lee
Published on:

EDTF adoption might regain investors’ trust; Report deserves credit as private-sector solution

At the end of October, the Enhanced Disclosure Task Force (EDTF), a body with bank and investor members presented a report to Mark Carney, chairman of the Financial Stability Board and governor of the Bank of Canada. It contained more than 30 hard-hitting recommendations for how banks could improve disclosure, and banks and investors began digesting them last month.

In the aftermath of the financial crisis, investors have grown increasingly suspicious that many banks have been underestimating the deterioration in credit quality of their loan portfolios, perhaps even with the tacit connivance of national regulators keen to avoid panic in their banking systems.

They are also concerned that certain banks have used questionable internal models to give favourable outcomes when calculating their own risk-weighted assets and regulatory capital ratios, and employed end-of-reporting-period risk-collapsing transactions to obscure the true level of liquidity and other risks they might be running in the regular course of business.

The EDTF wants banks to rethink their own voluminous disclosures to better present – in clear, balanced and accessible formats – accurate, relevant and comprehensive data on the key risks they run in ways that are consistent over time and comparable across banks.

Specific recommendations include that banks should: provide granular information to explain how RWAs relate to business activities and risks; present tables showing capital requirements for each method used for calculating RWAs for credit risk and counterparty credit risk for each Basle asset class; tabulate credit risk in the banking book showing average probability of default, loss given default and exposure at default, as well as RWAs and RWA density for Basle asset classes and leading portfolios within those classes; describe how banks manage potential liquidity needs and provide a quantitative analysis of the components of liquidity reserves, ideally by providing averages as well as period-end balances; and summarize encumbered and unencumbered assets in a tabular format by balance-sheet categories, including collateral received that can be rehypothecated.

There are a series of similar recommendations across market and other risks, including operational and legal risk.

Is this yet another long report of well-meaning recommendations – note, they are not regulatory requirements – that banks can halfheartedly commend and then quietly ignore amid the welter of other more pressing regulatory impositions?

Alastair Ryan, bank equity analyst at UBS, says: "Compared with the start of the financial crisis, there is little now that’s important to us that we don’t get from banks. And while there is a reasonable debate to be had whether all banks should give us what now only some banks do, and present it in comparable formats, you need to remember that explanations over funding, liquidity risk and RWA treatment often come through in management discussions rather than audited numbers."

He also suggests the heat is already coming out of what were the most contentious areas just 12 to 18 months ago.

"We have little time for this discussion on inconsistent risk-weighted asset calculations for similar portfolios," says Ryan. "We have looked and cannot find any pattern for this. If you take portfolios of similar loans at different banks, over time the difference in risk weights is not going to be that big. If banks’ actual loss experience differs from what their models suggested over a number of years, then regulators will force them to change their models."

However, investors remain suspicious and want clarity on how recently fast-moving changes in banks’ reported RWAs reflect simply balance-sheet reduction, changes to the actual retained risk, or model changes.

Russell Picot, chief accounting officer at HSBC
Russell Picot, chief accounting officer at HSBC
Russell Picot, chief accounting officer at HSBC, co-chaired the task force. He says: "Possibly the most important suggestion in the report is for an RWA flow statement that would show, among other things, how model changes affect RWAs, the key inputs into models for calculating RWAs, including the length of data sets used, and whether models are approved by regulators or self-certified. No bank that I know of currently supplies such a statement."

The need for this springs from a general worry about opacity of bank statements.

Picot says: "What investors were telling us is that it’s hard to understand bank business models and how they relate to the risks banks take and how those business models and risks actually show up in the balance sheet and the profit and loss.

"That has been because reporting is quite compliance based and that has led to reports hundreds of pages long, with important disclosures scattered throughout but not presented in a way that conveys a clear and readily understandable picture of what banks do."

Regulators must be impressed that the private-sector task force took just five months to produce its recommendations and that they are quite forceful. They will want to see banks comply. Banks have a lot to gain by giving investors the disclosures they want. When banks were supported by implicit sovereign guarantees, investors could swallow this opacity more easily than they can now in the era of too-big-to-fail and bail-inable debt.