Bank Risks Must Be Made Clear to Investors

The global financial crisis highlighted the systemic risk posed by large, complex banks. Six years later, investors remain daunted in their attempts to fully comprehend and discern the range of risk exposures that these entities face. While banks periodically provide huge reams of annual and interim reports, they remain notoriously opaque: readers of financial statements have difficulty readily discerning and aggregating key risks.

This state of affairs constrains the investability of banks. Bank reports must shift to reflect economic realities and the full risk exposures of bank balance sheets.

A recent CFA Institute study of 51 banks in the United States, European Union, Canada, Japan and Australia assessed key factors that have influenced banks' low price-to-book ratios since the beginning of the financial crisis. (Price-to-book ratios compare a stock's market value to its book value.)

Using data from 2003 to 2013, the study found that investor risk aversion has contributed to banks' low price-to-book ratios, along with a diminished outlook on banks' prospects for profitability and delayed financial asset write-downs. These low price-to-book ratios signal that investors are effectively discounting reported book values as they struggle to trust reported numbers.

Several initiatives aimed at enhancing transparency in bank reporting are underway. The main global accounting standard setters—the International Accounting Standards Board and the Financial Accounting Standards Board—have, to varying degrees, overhauled and updated their requirements. The Financial Stability Board's Enhanced Disclosure Task Force—a coalition of investors, banks and auditors—has also made recommendations for improving banks' risk reporting in key areas such as capital adequacy, credit risk, liquidity and funding risk, market risk and risk governance.

These reforms should help investors better judge the relative performance of banks. Yet there is more work to be done in targeting challenging areas within the current reporting framework.

One lingering problem is that reported line items sometimes fail to faithfully represent economic reality. For example, it is widely acknowledged that the currently required incurred-loss methodology—wherein write-downs occur only after a triggering event, such as an actual default—led banks to delay writing downs loans in the run-up to the financial crisis.

The new standards proposed by both the IASB and FASB adopt different variants of the expected loss methodology, which in broad terms requires banks to recognize all the expected losses over the lifetime of loans. These standards should result in more timely write-downs, helping to give investors a clearer picture of banks' credit risk.

Although the move to expected loss methodology may be a step in the right direction, the CFA Institute still views it as the lower bound of desirable reform. An even more favorable approach would be to require banks to report both fair value and amortized cost amounts on their income statements and balance sheets, rather than disclosing fair value amounts only in the notes. Banks currently tend to lack rigor in quantifying fair value loss amounts, perhaps because those numbers receive limited regulatory scrutiny.

Our study also found that it is often difficult to compare income statement and balance sheet line items. One case in point is that it is hard to compare the total assets of U.S. banks to those of foreign banks that report to the IFRS, since the accounting standards include different derivatives-offsetting requirements. More troublingly, it is a challenge to compare line items such as loan impairments even across banks that have the same accounting standards, such as the IFRS.

More work must also be done to improve comparability in financial reporting. If the IFRS and the FASB matched offsetting requirements, total assets and leverage can be compared across key economies.

The same problem arises in the lack of convergence on the broader financial instruments updates. Regrettably, both boards have failed to come to common requirements on the three key phases of the financial instruments accounting: classification and measurement, impairments and hedge accounting.

This means that investors will continue to have a hard time comparing the performance of banks internationally.  Differing accounting standards for the same financial assets and liabilities increase the need for expanded disclosures, which would help investors identify whether balance sheets can be meaningfully compared across countries.

Another continuing issue is banks' failure to comprehensively report risk exposures in a manner that is readily accessible by investors.  Banks often fail to display key information in an accessible manner. Their annual reports disperse related information across different sections, making it harder for investors to get a complete portrait. And they draw few connections between related items in their regulatory risk reporting and financial statement disclosures.

These issues demonstrate the need for new disclosures, as recommended by the enhanced disclosure task force. Disclosures should provide granularity and context to key risk areas. They should also enable investors to make bottom-line judgments about how economic changes will impact banks, such as how an interest-rate hike will affect bank profits and capital.

It is clear that in the run-up to the financial crisis, investors failed to adequately exercise market discipline because of inadequate disclosures. This in turn contributed to moral hazard and excessive risk-taking by banks.

The way forward is to enhance risk reporting so that investors can more fully understand how risks translate to financial performance and are ultimately reflected in the balance sheet. Today's investors realize how little they understand about bank risk exposures, and the banking industry is suffering as many investors continue to be skittish about providing risk capital. Restoring investor trust and confidence can help solve the problem—but there is plenty of ground to be covered before this goal is adequately achieved.

Vincent Papa, CFA, is a director of financial reporting policy at CFA Institute. He is responsible for representing the interests of CFA Institute on financial reporting proposals before the International Accounting Standards Board and the U.S. Financial Accounting Standards Board. Papa holds a PhD.