Bank risk reporting and legitimacy theory

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Method

The authors of this case study have used a quantitative content analysis in order to ana-lyse the risk disclosures of the sample banks. The study focuses solely on the infor-mation existing in the consolidated annual reports and risk reports, provided by five Eu-ropean banks and therefore, analysis has not been made on information from the banks‟ websites. The reason for this is that the websites are constantly updated and therefore may not give comparable information regarding previous years. Using annual reports made the data collection equivalent over time and across banks. Considering that the main tool for delivering information regarding risk reporting are the annual reports, this was the most important source of information for data collection and the foundation to chart the changes in risk disclosure. Previous research has also been considered in order to increase the understanding of risk disclosures concerning financial institutions. Some of the sample banks have chosen to have their full risk report as a separate complimen-tary document to their annual report. In these cases the authors have read the separate risk report, as this is the text equivalent to those sections the other banks have in their annual reports.
Further data has been collected by reviewing academic articles, which were found in the database ABI/INFORM, relating to risk disclosure, the banking industry, Pillar 3 as well as IFRS 7. There are some data collected from websites as well as books and corporate issued reports from regulatory bodies. The years of examination are 2010 through 2013, resulting in four years of analysis of annual reports on five different banks. The reason for not including the 2014 annual reports was that not all banks had issued them and therefore the latest year reviewed is 2013. This method and sample size was chosen by the authors since it is considered to be the most suitable in order to answer the research question stated in section 1.3 and since equivalent studies have used the same approach which strengthen the comparability of the outcome.

Sample selection

The sample for this study was selected from a list of 29 banks found in the report High-level Expert Group on reforming the structure of the EU banking sector (European Commission, 2012). The selection was based on the geographic location of the banks and their connection to the European Union. The selected banks are all listed and operate in Belgium, Denmark, Germany, The Netherlands and The UK. Furthermore, these countries have all been members of the European Union for over 30 years and were some of the founders as well as the first countries accepted. Therefore they have a strongly rooted connection with all the developments regarding regulations and recom-mendations which have been issued over time by the European Union and its subordi-nates (European Parliament, 2002). Another reason for choosing these five banks were that they all have a separate Risk Committee, which report to and work in congruence with the board of directors. This further enhances the comparability between the sample banks. All sample banks are among the largest in their respective country. In Table 3-1 below the sample banks are summarised based on their respective market capitalisation, and on total assets derived from the consolidated annual reports as of accounting year-end December 31, 2013. In order to ensure comparability the total assets and market capitalisation of Danske Bank and Royal Bank of Scotland (RBS) were converted to eu-ros (Appendix 1).

Data analysis

This case study is based on the concept of a study conducted by Linsley et al. (2006) on risk disclosure in UK and Canadian banks. Their study was conducted on financial insti-tutions and was based on a previous study by two of the authors in 2005, which focused on non-financial companies (Linsley & Shrives, 2005). The authors implemented con-tent analysis in order to analyse the risk disclosures found in the selected banks‟ annual reports. In order to quantify the disclosures of risk information and risk management the authors counted sentences relating to said subjects. The data from the annual reports was then coded and a disclosure coding grid based on Pillar 3 was developed, which can be seen in Appendix 3.
The created coding grid has been used for this study on risk disclosure of the five banks; however some modifications were made to it. The coding grid applied in this study fo-cuses on credit risk, market risk and operational risk, which all were included in the original grid. Additionally, liquidity risk was added as a fourth risk based on the re-quirements found in IFRS 7 (IFRS, 2005). The remaining risks considered in the orginal grid will therefore be ignored in this study. However, in this study not only sentences were analysed, as in the Linsley et al. study in 2006, but also numerical and tabular in-formation was included. The disclosure characteristics based on „Quantita-tive/Qualitative‟, „Good news/Neutral/Bad news‟, „Past/Future‟ and „Definitions‟ were kept as in the original disclosure grid. These characteristics can be grouped into twelve different combinations, which can be seen in the coding grid constructed for this study in Table 3-2 below.
In order to set up the coding guidelines the authors together read one bank‟s annual re-ports for the four years chosen for examination. This to ensure that each annual report was coded in the same way, even when the authors read them independently. Examples of coding guidelines are for instance that if a specific risk could not be identified as one of the four risks chosen for this study it has not been included as a disclosure. Another guideline has been that if more than one risk has been identified in the same disclosure then it has been categorised as the risk most emphasised.
Therefore the data collection was conducted as follows. The data was first analysed sep-arately by each of the authors for one bank at a time by marking the information in the annual reports using Adobe Reader. Once all four years were analysed the authors met and compared their results. On occasions where the results differed the authors had a discussion in order to figure out which characteristic was the most accurate one. The re-sults were then entered into the disclosure grid and compiled in tables and figures using Microsoft Excel. However, the definition characteristic was excluded from some of the compilations due to that it has no natural opposite. The tables and figures illustrate the proportion of disclosures in terms of the different characteristics as well as the number of disclosures. The compilations were first done for each bank and year, followed by a table of the aggregated results per year. Finally, a table comprising all risk disclosures for all sample banks and years was constructed.
When reading the annual report the „Quantitative/Qualitative‟ characteristic has been analysed based on if the information disclosed can be argued to be of value and have quality for the stakeholders. If the disclosure contained detailed descriptions, explana-tions or numbers it has been considered as a qualitative type of information. If the dis-closure merely gave brief information relating to the risk it has been seen as quantitative information. The „Bad news/Neutral/Good news‟ characteristic has been based on if the information holds a positive2 or negative3 tone. If it does not appear to be of a positive or negative nature it has been considered to be neutral. The „Past/Future‟ characteristic, which considers the time perspective, the authors have considered risk disclosures relat-ing prior to the year of the annual report, as well as events of the current year to be past tense information. Information which relates to potential upcoming risks has been con-sidered as future tense. As for the „Definition‟ characteristic it has been considered to be a disclosure which helps increasing the understanding of the risks for the reader. If a risk disclosure is not considered to be a definition it is another type of disclosure based on the requirements for the other types of characteristics.

Validity and reliability

In this study the authors have collected information and data from annual reports of the sample banks. This information is deemed as highly valid and reliable since businesses are required to ensure that the information in their annual reports convey a true and fair view of their organisation and its operations (Mallin C. A., 2013). Furthermore, this in-formation has been audited by en external party, further reducing the chances of it being altered or manipulated. The collected information regarding the regulatory frameworks has mostly been taken directly from the organisations issuing them and therefore it is considered to also have a high degree of validity and reliability.
The outcome of a study like this will always be influenced by who is conducting it, and what previous knowledge they have, as well as how they interpret the information and the risks. Concerning the coding of the annual reports the authors have a limited previ-ous experience, which can have a negative impact on the empirical findings since the disclosures could be interpreted incorrectly. Moreover, there is a risk of relevant disclo-sures being neglected as they are not stated clearly, in terms of the above mentioned cri-teria‟s, in the annual reports. Reliability has also been provided through that the authors have thoroughly rechecked and scrutinized the risk information disclosed by the banks. Considering the limited experience combined with the thorough work the study is con-sidered to hold high objectivity and to be both reliable and valid.

Empirical findings and analysis

In this study a total of 2,149 risk disclosures were identified within the sample of 20 an-nual reports over the time period of four years. The distribution of the four risks studied can be seen in Figure 4-1 below, which illustrates the total amount of disclosure per risk and year. It has been acknowledged that most of the risk disclosures found relates to credit risk with 976 disclosures in total, which is not surprising considering banks are high risk-oriented lending institutions. The second largest risk type in this study was market risk, which had 536 disclosures in total distributed evenly over the years with an exception for a small decrease in 2012. Liquidity risk and operational risk are the two least disclosed risks and rather equalled distributed, where liquidity risk had 335 disclo-sures in total and operational risk had 302 disclosures.

Empirical findings

In the sections that follow the empirical findings of this study will be illustrated in ta-bles comprising the risk disclosure results per year and the proportion of disclosure characteristics. The number of disclosures includes the results for all sample banks. As stated in section 3.2 the „Definition‟ characteristic will be ignored in the summary of risk characteristics and the summary of risk types. All disclosure grids for respective bank and year can be found in Appendix 3 through 8. In Appendix 9, a disclosure grid comprising all disclosures for all years and sample banks can be found.

Risk categorisation and summary of disclosures 2010

For 2010 a total of 538 risk disclosures were recognised within the sample of annual re-ports and risk reports. From Table 4-1 below it is illustrated that the „quantita-tive/neutral/past‟ characteristic is the most frequent one with 194 disclosures. Further one can see that credit risk is the most dominant risk with 238 disclosures, followed by market risk which had 135 disclosures. Operational risk with 82 disclosures is almost equal in terms of number of risk disclosures to liquidity risk, which has 83 disclosures for 2010.
Table 4-2 summarise the proportion of risk disclosure characteristics for 2010. The dis-tribution between quantitative risk disclosures and qualitative risk disclosures are ap-proximately 60 per cent compared to 40 per cent. Disclosures relating to the past by far outnumber those relating to the future with roughly 83 per cent compared to 17 per cent. In 2010 the sample banks disclosed good news rather than bad news; however the neu-tral disclosures were the most significant characteristic with almost 77 per cent.

Risk categorisation and summary of disclosures 2011

In 2011 the total amount of risk disclosures was 536 and like previous year the „quanti-tative/neutral/past‟ disclosure was the most frequent with 163 disclosures, which can be seen in Table 4-3 below. This year the allocation of the disclosures are more scattered between the four types of risk than previous year. Credit risk maintains the most domi-nant risk type disclosed with 236 disclosures followed by market risk, which had 138 disclosures. However, operational risk has decreased since 2010 and now has 72 disclo-sures, whereas liquidity risk has increased to 90 disclsoures leading to a more distin-guished gap between the four risks.
Illustrated in Table 4-4 below one can see that the proportion of quantitative risk disclo-sures and qualitative risk disclosures are more even than previous year. This year the distribution of these disclosures is approximately 56 per cent compared to 44 per cent. In 2011 the past disclosures decreased slightly, with the corresponding increase of fu-ture disclosures. There has also been a slight change in the proportion of the „good news/neutral/bad news‟ characteristics. The bad news disclosures have increased lead-ing to a decrease in both good news disclosures as well as for neutral disclosures. How-ever, bad news is still the least disclosed type of news and neutral remains the most common.

Risk categorisation and summary of disclosures 2012

In 2012 the total amount of risk disclosures equalled 532, which are summarised in Ta-ble 4-5 below. „Quantitative/neutral/past‟ is still the most frequent disclosure character-istic with 180 disclosures. This year the market risk disclosures were 124, which almost equal half of the disclosures of credit risk, which has 244 disclosures. The reason for this is an increase in credit risk disclosures in connection with a decrease in market risk disclosures. In 2012 the operational risk disclosures has increased and liquidity risk dis-closures has decreased, resulting in a now equal distribution of 82 disclosures respec-tively for the two risks.
The proportion of quantitative and qualitative disclosures in 2012, which is summarised in Table 4-6 below, has slightly changed compared to the previous year. The percentage distribution this year has changed by two percentages for each characteristic, resulting in 58 per cent for quantitative disclosures compared to 42 for qualitative disclosures. The past disclosures now equal over 83 per cent, which is in an increase not only since the decrease in 2011, but also compared to the 82,89 per cent in 2010. This year the good news disclosures have increased by almost 4 per cent, bad news has decreased by 3 per cent and neutral disclosures decreased by 1 per cent compared to 2011.

Risk categorisation and summary of disclosures 2013

For the final year of the study a total of 543 risk disclosures were identified within the sample. In Table 4-7 below it is illustrated that the „qualitative/neutral/past‟ characteris-tic is the most frequent with 178 disclosures, which differs from the three previous years studied where the „quantitative/neutral/past‟ characteristic was the most common. How-ever, it is still the credit risk with 258 disclosures this year that is the major risk type followed by market risk with 139 disclosures. As in 2011 this year the operational risk and liquidity risk are more scattered than they were in 2010 and 2012. This year opera-tional risk held 66 disclosures compared to liquidity risk which now has 80 disclosures.
Summarised in Table 4-8 below are the risk disclosure results for 2012 and this year holds the most equal distribution of quantitative and qualitative disclosures out of all four years studied. The distribution between these disclosures this year is 51 per cent compared to 49 per cent. This year also holds the largest difference between past and fu-ture disclosures. The future disclosures have decreased to almost 10 per cent, resulting in an increase for the past disclosures to approximately 90 per cent. For the final charac-teristics the good news has decreased by almost 1 per cent. The bad news disclosures have increased by almost 5 per cent and the neutral disclosures have decreased by roughly 4 per cent.
Summarised in Table 4-8 below are the risk disclosure results for 2012 and this year holds the most equal distribution of quantitative and qualitative disclosures out of all four years studied. The distribution between these disclosures this year is 51 per cent compared to 49 per cent. This year also holds the largest difference between past and fu-ture disclosures. The future disclosures have decreased to almost 10 per cent, resulting in an increase for the past disclosures to approximately 90 per cent. For the final charac-teristics the good news has decreased by almost 1 per cent. The bad news disclosures have increased by almost 5 per cent and the neutral disclosures have decreased by roughly 4 per cent.

Analysis of the disclosure characteristics

When studying the first characteristics, „Quantitative/Qualitative‟, one can see that the quantitative disclosures dominated. They ranged from 50.73 per cent to 60.08 per cent whereas the qualitative disclosures ranged from 39.92 per cent to 49.27 per cent. How-ever, in 2013 the proportions were almost equal, where quantitative disclosures held 50.73 per cent and qualitative disclosures were 49.27 per cent. The results from 2013 is in line with the developments following the financial crisis mentioned in section 2.3, which stated that the quality of annual reports has been improved and the information has become more comprehensible for the stakeholders. Both quantitative and qualitative disclosures generate quality for the reader of the annual report. If the proportion be-tween these two disclosure types are equal one can assume that the report holds as high quality as possible, since it contains both the necessary basic information (quantitative disclosure) and the more descriptive information (qualitative disclosure). Out of the four years of this study only 2013 held an almost equal proportion. This is in line with Pillar 3 and IFRS 7, which states that banks are expected to disclose both quantitative and qualitative information in order to provide a broad understanding of its risk profile to the market participants.
When comparing the tense characteristics it is evident that the past tense by far outnum-bers the future tense. This result is in line with what has previously been stated regard-ing damages to legitimacy. Revealing too much information regarding risks in the future may jeopardise the trust of the stakeholders and could potentially endangers their mar-ket position. If the stakeholders perceive the bank to have a high future risk profile, they may be inclined to move their assets to a bank they perceive to be more secure and sta-ble. Furthermore, it is by nature easier to disclose information regarding risks you have encountered in the past since they have been managed. Future risks are subject to specu-lations and therefore the bank can only reflect its expectations of the risk and how they would act if it was realised, which can be an explanation for why the future risk disclo-sures are limited in the annual reports. The proportion of the two tenses was quite stable for the years 2010 through 2012 ranging from 81.78 per cent to 83.05 per cent for past tense and from 16.95 per cent to 18.22 per cent for future disclosures. However, for 2013 the past tense disclosures increased to 89.60 per cent compared to the 10.40 per cent for the future tense disclosures. As mentioned previously, in section 2.2, future re-lated disclosures are considered more qualitative for decision makers. However, due to the above mentioned reasons the low proportion of future disclosures is quite expected and reasonable.
For the final characteristics, „Bad news/Neutral/Good news‟ it is clear to state that the neutral characteristic is the most prominent. The bad news characteristic has the lowest proportion each of the four years of study, which is logical since disclosing too much negative and bad information may damage the legitimacy and the perception the stake-holders have of the business. The proportion of bad news disclosures for the four years has ranged between 5.02 per cent and 9.98 per cent. Comparing this to the good news disclosures, which has ranged from 15.47 to 19.46 per cent, and the neutral disclosures ranging from 71.73 to 77.19 per cent, one can see that they represent a small part of the total disclosures. However, some bad news will be required to be disclosed in order for the bank to avoid risking suspicion of hiding problems. In this study it was observed by the authors that most of the bad news disclosures related to the past as well as that they had been dealt with. Furthermore, they were usually followed by good news disclosures which can be considered as a way of repairing legitimacy resulting in a stronger percep-tion by the stakeholders as well as minimising legitimacy gaps.

Discussion

This study has investigated development of risk disclosures for five banks and as can be interpreted from the analysis no clear development was observed. The authors had ex-pected to find a distinctive increase in terms of total number of disclosures between the years 2010 and 2013. This since most previous studies have found such a development in risk reporting as well as that the regulatory requirements have kept improving over the years.
One reason for the absence of a clear development may be the deep connection all coun-tries represented in this study has to the European Union. As stated in the method sec-tion, all five countries have been members of the European Union for over 30 years and has been a part of the developments of the regulatory requirements over these years. The developments were more extensive following the 2007 – 2008 financial crisis, but today most new regulations are adjustments to previously issued guidelines. This may be a reason for the low amount of total disclosures for the four years of this study, since neither Pillar 3 nor IFRS 7 has had any major amendments during this time.
Another reason for the low outcome may be that most banks reuse information from previous years‟ risk reports and the authors have only focused on certain risk types. Re-using information may have a negative impact on the meaningfulness of the disclosures, since it does not add new value for the reader. Moreover, the preferences and norms of society changes over time and if the bank does not pay attention to it they risk increas-ing the legitimacy gap by disclosing information that does not meet expectations of the stakeholders. However, the authors observed an increase in risk reporting for each year both in terms of page numbers as well as risk disclosures for other risks not included in this study. Considering that the amount of risk disclosures is not associated with the number of pages, as previously mentioned, one may question the transparency and qual-ity of the risk disclosures. This is connected to previous research, which has shown that a large amount of disclosures does not result in transparency or quality for a bank‟s stakeholders. Therefore, it is questionable if the annual report is the most suitable place for risk disclosures. The authors consider the solution of Danske Bank and Rabobank to be more efficient and valuable for the reader. These two banks have a separate docu-ment containing the extensive risk report and their annual reports only holds the risk in-fomartion required by the regulations.
Another reason for why the banks today have a more extensive risk reporting, including all risks, may be due to that they wish to maintain a certain level of legitimacy. An ex-tensive risk reporting reassure the stakeholders that the bank is not involved in any fraudulent activities, and that they are well prepared for any potential financial shocks in the future.
As the empirical findings show, the largest amount of disclosures relate to the neutral characteristic and that the least used characteristic is bad news. This may be expected since it may damage the reputation of the bank and trust of the stakeholders if they dis-close too many bad news. However, considering that the neutral disclosures are so evi-dently dominant stakeholders may suspect that the bank is withholding risk information. The reason from the bank‟s perspective may be that they wish for the reader themselves to judge whether the disclosure is good or bad news. The risk with this approach is that people interpret information differently, and what some think is good news others may consider bad news and vice versa.
In terms of total assets one may assume that a larger bank would disclose more infor-mation regarding risks than a smaller bank. This since they hold a larger amount of stakeholders with higher expectations on the bank compared to other actors of the fi-nancial institutions market. In this case study the largest bank in terms of total assets is RBS; however, they did not generate more risk disclosures than any of the other banks.
Overall, this case study will not draw any general conclusions in terms of the develop-ment of risk disclosures due to the nature of the study. This since the sample size is small and that the authors have only focused on four types of risks. In order to evaluate what kind of development the risk disclosure reporting has had a more extensive time period would be required combined with including all types of risks. The sample would also need to include banks of different sizes in order to give a true and fair view of the market. Furthermore, there are very few previous studies which discuss the subject of risk reporting in financial institutions to compare the results with, which makes it diffi-cult to establish whether there has been a development or not. As for this study the re-sult for 2013 was quite different and interesting in terms of number of disclosures and the proportion of characteristics. Since the annual reports for 2014 were not available for all sample banks it was not possible for the authors to see if this change would be continuous.

Table of Contents
1 Introduction
1.1 Background
1.2 Problem
1.3 Purpose
1.4 Outline of the thesis
2 Bank risk reporting and legitimacy theory
2.1 Definition of risk
2.2 Importance of bank risk disclosure
2.3 Bank risk disclosure development
2.4 Legitimacy theory
3 Method
3.1 Sample selection
3.2 Data analysis
3.3 Validity and reliability
4 Empirical findings and analysis
4.1 Empirical findings
4.2 Analysis
5 Discussion
6 Conclusion
7 Bibliography
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